A Dozen Lessons about Product and Services Pricing (Including being “Too Hungry to Eat”)

This is a blog post about some of the most basic elements of pricing a product or service. Since the longest a post like this should be is about 3,500 words, the scope of what is covered here must be significantly narrowed. This discussion therefore focuses mostly on the sale of a single product or service and on the right price point. Decisions get more complex when there are multiple offerings with different price points for different features and you are thinking about upsell, cross sell, negative churn etc.

As context, I have written many other blog posts already about topics related this post including:

  1. Product/market fit: https://25iq.com/2017/02/17/a-dozen-lessons-about-productmarket-fit/
  2. Steve Blank on business models https://25iq.com/2014/10/18/a-dozen-things-ive-learned-from-steve-blank-about-startups/
  3. Eric Ries on Lean Startups https://25iq.com/2014/09/28/a-dozen-things-ive-learned-from-eric-ries-about-lean-startups-lattice-of-mental-models-in-vc/
  4. Growth: https://25iq.com/2017/02/10/a-dozen-lessons-on-growth/
  5. Customer Acquisition Cost (CAC) https://25iq.com/2016/12/09/why-is-customer-acquisition-cost-cac-like-a-belly-button/
  6. Churn https://25iq.com/2017/01/27/everyone-poops-and-has-customer-churn-and-a-dozen-notes/
  7. Freemium: https://25iq.com/2017/04/22/the-rise-of-the-freemium-business-model/
  8. Multi-sided markets: https://25iq.com/2016/10/22/a-dozen-things-ive-learned-about-multi-sided-markets-platforms/
  9. Network effects: https://25iq.com/2016/03/24/two-powerful-mental-models-network-effects-and-critical-mass/
  10. Subscriptions: https://25iq.com/2017/07/15/amazon-prime-and-other-subscription-businesses-how-do-you-value-a-subscriber/

This post will be number 11 in this series and a post next weekend on scalability will be number 12. That will result in the series of 25IQ blog post fitting the usual dozen lessons template.

The first focus of any startup founder should be to prove the validity of a value hypothesis. If a business does not make a product or service that customers are willing to pay money for, nothing else matters. Anu Hariharan, who is a Partner with the YC Continuity Fund writes:

“A great way to waste money, resources, and jeopardize the future of your company is to invest in a growth program before you’ve proven you can retain customers. In other words, it’s best not to hire a full-fledged growth team to put major ad dollars into growth until you’ve ensured you don’t have a ‘leaky bucket’ problem.’”

The amount of unique value delivered by a new business should be significantly more than the established competition if a startup wants to be successful. If the value delivered by the business is “me too” relative to existing competitors the competitive environment will be is more than hard for a startup.

Only after the value hypothesis has been proven should the startup focus on a growth hypothesis. A key part of the growth hypothesis is the business model and a key part of that is pricing. The question of pricing raise many issues, one of which Marc Andreessen addressed recently:

“At the growth stage, when a startup is fully in market and building out sales and marketing efforts to expand, the decision [to invest] becomes far more about the financial characteristics of the business—particularly unit economics: can the startup profitably sell its product to each customer?… we see far more SAAS startups underpricing their product than overpricing.

The problem with overpricing seems obvious—we in our daily lives as consumers are more likely to buy products if they are cheaper, and so pricing higher is presumed to reduce sales.

But that’s not how business markets tend to work—in business markets, where customers make what’s called a considered purchase, the result of a reasonably objective and rigorous analysis of options, startups that underprice tend to have the problem I call “too hungry to eat”—by pricing too low, they can’t generate enough revenue per deal to justify the sales and marketing investment required to get the deal at all. In contrast, by pricing higher, the startup can afford to invest in a serious sales and marketing effort that will tend to win a lot more details than a competitor selling a cut-rate product on a shoestring go-to-market budget.”

There are many types of businesses and each has unique attributes that are in a constant state of change. There are an endless number of permutations of the relevant variables and the systems involved in the business. Nothing remains the same and everything is always in flux. That is no small part of what makes business so interesting to me.

This post can’t possibly discuss pricing optimization for every type of business since there is so much variation. For example, gross margins can vary greatly depending on the sector involved (DM means developed markets). But general principles and best practices can be discussed. Gross margins are a very important part of creating an optimal pricing strategy:

gross margins

I don’t want to insult anyone reading this but I don’t want to leave anyone behind either (this tension between expert readers and novices is always a challenge in writing these posts). What’s a gross margin? Lighter Capital provides an example:

“ABC Company buys Widgets for $1 and can sell each Widget for $10. On each sale, they make $9. The gross margin for this company is 90%. On the other hand, XYZ Company buys Thingies for $5, and sells each Thingy for $10.

ABC Company

XYZ Company

Sale (One Unit)

$10

$10

Cost of Goods Sold

$1

$5

Gross Profit

$9

$5

Gross Margin

90%

50%

Assuming all else is equal, ABC Company has a higher margin on their sale (90% vs 50%)..”

To further make the discussion in this blog post more manageable by limiting its scope I will mostly focus the text that follows on a “software as a service” business (SaaS). Gross Margins in public SaaS companies look like this according to data compiled by venture capitalist Tomas Tunguz:

gmt

“…investors prize SaaS companies because providing SaaS service costs very little, and consequently these startups record very high gross margins. The median gross margin for publicly traded SaaS companies expands from 50% in year four to just under 75% in year five, as the chart above shows.”

Why are gross margins so high in SaaS? The answer is explained well by Andreessen Horowitz in a blog post:

“Paraphrasing Jim Barksdale (the celebrated COO of Fedex, CEO of McCaw Cellular, and CEO of Netscape), ‘Here’s the magical thing about software: software is something I have, I can sell it to you, and after that, I still have it.’ Because of this magical property, software companies should have very high gross margins, in the 80%-90% range. Smaller software companies might start with lower gross margins as they provision more capacity than they need, but these days with pay-as-you-go public cloud services, the need for small companies to buy and operate expensive gear has vanished, so even early stage companies can start out of the gate with relatively high gross margins”

Bill Gurley lays out the value of high gross margins for a business here:

“There is a huge difference between companies with high gross margins and those with lower gross margins. Using the DCF framework, you cannot generate much cash from a revenue stream that is saddled with large, variable costs. …Selling more copies of the same piece of software (with zero incremental costs) is a business that scales nicely. Companies that are increasing their profit percentage while they grow are capable of carrying very high valuation multiples, as future periods will have much higher earnings and free cash flow due to the cumulative effect of growth and increased profitability.”

 Bill Gates in 1993 described what Bill Gurley is talking about in this way:

“It’s all about scale economics and market share.  When you’re shipping a million units of Windows software a month, you can afford to spend $300 million a year improving it and still sell it at a low price.”

One useful way to better understand the context and implications of what Andreessen, Gurley and Gates are saying is to follow the Charlie Munger approach and “invert” the analysis. If a SaaS  business has 60-90% gross margins it has headroom “below the gross margin line” to spend on these three expensive and unavoidable aspects of their business:

  1. Research and Development (R&D)
  2. General and Administrative (G&A)
  3. Sales and Marketing. (S&M).

What I typically do when considering the economics of a business is perform a “reverse math” analysis of business financials using well-known benchmarks. Like almost every other business, the SaaS company will have familiar categories of expense. To illustrate, I will use an example of a specific software as a service (SaaS) business serving enterprise markets which recently went public so we have access to an IPO that is not too dated. MuleSoft’s financials in that document include this chart:

mulesoft

You can see that MuleSoft’s gross margin was 74% in 2027.  Tomas Tunguz notes that MuleSoft’s gross margin:

“is better than the public software average of 71%. Professional services margins used to be -25%, but the company has brought that figure up to breakeven in the last year. This may also be a contributing factor to the increase in average contract value.

mule inc

Mulesoft is rapidly approaching cash flow from operations breakeven and net income profitability. Cash flow from operations breakeven means the business generates as much cash as it consumes setting aside financing and investing activities. Mulesoft operated with an estimated sales efficiency of 0.57 in 2015 and a estimated sales efficiency of 0.63, which implies a payback period of 19 months, right on the average.”

MuleSoft’s R&D and G&A alone are 35% of revenue, which leaves less room for spending on sales and marketing needed to grow the company. Every business has general and administrative costs. To illustrate:

mule GA

Every SaaS business also has R&D costs (this cost can range between 10 and 30%nd should drops as the company matures and is operated more effectively).

“In general, R&D expenses (as measured as a percent of revenue) for public SaaS co’s are lower than traditional licensed software companies.  Unlike licensed software vendors, SaaS companies are not required to support multiple technology stacks (i.e., operating systems, Web servers, databases, etc.) or a variety of hardware platforms.  Additionally, SaaS solutions are typically version-less (all customers are on the same version) thereby enabling critical R&D dollars of the organization to focus on the next version and innovation.”

The next item on the list of below the gross margin line expenses is sales and marketing. This is an expense that can easily kill a business or make it a winner. The very best companies have products that sell organically. Bill Gurley writes:

“All things being equal, a heavy reliance on marketing spend will hurt your valuation multiple. …You will be hard pressed to find a company with a heavy marketing spend with a high price/revenue multiple. This should not be read as a blanket condemnation of all marketing programs, but rather a simple point that if there are two businesses that are otherwise identical, if one requires substantial marketing and one does not, Wall Street will pay a higher valuation of the one with organic customers.” Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend.”

As an example of how complex pricing issues can be, another important pricing issue is how a price will impact customer acquisition costs (CAC) and churn. I’ve been involved in setting services prices since there were zero portable mobile phones in service. That is a long time ago. One thing I have learned over the decades is that the higher the price and the longer the contractual commitment, the higher customer acquisition cost (CAC) and churn will be. If this were not the case all customers would be signing up for >10-year binding contractual commitments. People do not like to give up optionality by signing long terms contractual commitments, so sales incentives (e.g., price discounts) and higher sales and marketing costs are often required in order to get a longer customer commitment.

As another example of the complexity of pricing issues, when founders talk about SaaS they often assume the revenue is recurring. Many founders who think that they have recurring revenue really have 12-month deals. While this normal early on, especially for a pilot, it isn’t annual recurring revenue (ARR) if it is just payment spread over a year. This is especially true if there is no per-time period and per-user price. Until there have been renewals what is “recurring” in ARR is unknown.

Yet another issue is the topic of freemium or selling religious icons to the already converted. This can be a useful strategy to reduce CAC.  But you need to be careful since freemium results in higher COGs, which is hidden CAC. If you give away storage to get sales leads that isn’t really COGs now is it. It is just a different sort of sales and marketing spending.

What are most SaaS companies spending of sales and marketing? Tomas Tunguz writes:

“…In the first 3 years, these public SaaS companies spend between 80 to 120% of their revenue in sales and marketing (using venture dollars or other forms of capital to finance the business). By year 5, that ratio has fallen to about 50%….”

saasmarc

How should a SaaS company find the right price points for its services? They are best discovered through actual interaction with customers and a series of pricing experiments. The right price is discovered through a carefully constructed but inevitably slightly trial and error process. For example, a startup might start with its first paying customer and set a price. As the startup reels in new paying customers the business can gradually raise prices as it grows its customer base but only until it meets significant resistance on price.

This gets us to the related issue of setting price for a new category of SaaS. What I tell founders is that the best way to price of a new service that customers have not seen before is to set price so it produces sufficient gross margins so that the business has a margin of safety.  I like to see a business set a target of at least 70% gross margins on SaaS. It can be lower at the start of the effort but there must be a plan to get it higher. An 80% gross margin would be better obviously.  If a business can’t eventually get to a point where the business generates a 70% gross margin in a SaaS business it really needs to think hard about whether it has achieved sufficient product/market fit. A gross margin of 60% is living more dangerously obviously. Of course, most business have far lower gross margins than a SaaS business as was noted in the Median Gross Margins by industry chart above. But the more general point remains true for any business: if a startup is not able to generate better than industry standard gross margins it very likely does not have sufficient product/market fit.

Reid Hoffman believes:

People underestimate how much of an edge you need. It really should be a compounding competitive edge. If your technology is a little better or you execute a little better, you’re screwed. Marginal improvements are rarely decisive.” “The question comes down to…not to think of it just as a question of ‘Oh, I have a better product, and with a better product, my thing will work, as opposed to other things.’ Because unless your product is like 100x better, usually your average consumer…they use what they encounter. If other[s] are much more successful at distribution and they have much better viral spread, they have better index and SEO…it doesn’t matter if your product is 10x better, the folks don’t encounter it.”

If you deliver this sort of value, you can set your price on a value basis. Lincoln Murphy of Sixteen Ventures writes:

“The definition of Value Pricing is: Applying a price to a service that is congruent with the value derived from the service rather than the underlying cost to create and deliver the SaaS, market prices, specific margins, etc. Which makes Value Pricing the most effective method of pricing for SaaS and Web Apps… something like cost+margin just doesn’t make sense. The key to Value Pricing is knowing the, well, value of your service as perceived by your target market AND/OR market segments (not all are alike) … If I sell something for $100, I want to provide at least $1,000 in value to them… at least.”

As an example from another industry, let’s look at the New York Times which has gross margins that are typically about 62%. The New York Times has a yearly average revenue per user (ARPU) of  ~$140 which is ~ $11.66 a month.

NYT

Churn and CAC are known only to the management of the New York Times which means investors must guess at what they are to calculate unit economics. My post on unit economics is here. 

The New York Times, like other businesses, periodically conducts pricing experiments to see what it pricing power is. What is tested in these experiments is what Warren Buffett calls is  “pricing power” of the business. Buffett’s famous quote on this topic is:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

What determines pricing power? Whether the business has a sustainable competitive advantage, a topic that I wrote about in my blog post on Michael Porter. https://25iq.com/2013/08/26/a-dozen-things-ive-learned-about-strategy-business-and-investing-from-michael-porter-2/ and this post I wrote about Charlie Munger. https://25iq.com/2015/10/10/a-dozen-things-ive-learned-from-charlie-munger-about-moats/

Setting and managing prices is both an art and a science. Having a top rate data science team and some people who have real world experience are both invaluable. Many interacting variables are involved even before you start calculating and managing the business against metrics like lifetime value (LTV). The best way to learn the art and prefect the science is to actually create pricing plans for a business it in a real business setting. In setting and managing prices there are best practices, but there are no precise formulas. The more you do it, the more skill you will acquire.

Notes:

http://blog.ycombinator.com/growth-guide2017/#checkretention

https://stripe.com/blog/marc-andreessen-ama

https://a16z.com/2015/09/23/16-more-metrics/

http://abovethecrowd.com/2011/05/24/all-revenue-is-not-created-equal-the-keys-to-the-10x-revenue-club/

https://leadedgecapital.com/why-we-like-saas-businesses/

http://sixteenventures.com/saas-pricing-strategy

http://tomtunguz.com/mulesoft-s-1/

https://www.opexengine.com/are-ga-expenses-increasing-for-saas/

https://www.lightercapital.com/blog/calculating-gross-margin-for-your-saas-business/

 

 

 

A Dozen Lessons about Angel Investing from Jason Calacanis (Poker Edition)

This is the last post in my trilogy on how games of chance can teach lessons about investing and business. This first two were:

Ed Thorp: https://25iq.com/2017/07/22/a-dozen-lessons-on-investing-from-ed-thorp/

Poker and Investing: https://25iq.com/2017/07/29/a-dozen-lessons-about-business-and-investing-from-poker/

Blog posts about people are always more interesting and Jason Calacanis is nothing if not interesting. He is an entrepreneur and active angel investor (2-3 startups per month). He also created the six-year old podcast This Week in Startups and the Launch Festival. Calacanis is the founder and CEO of Inside.com, a real-time mobile news app. Calacanis co-founded and was the CEO of Weblogs, Inc., a network of weblogs that was sold to AOL in 2005. He is the author of a new book: Angel: How to Invest in Technology Startups-Timeless Advice from an Angel Investor Who Turned $100,000 into $100,000,000.  If there is one word that jumps to mind when I hear his name it is “hustle.” Calacanis is relentless and he works hard.

Venture capital investing is not gambling since it is a net present value positive activity. Venture capital speculation is gambling, since it is a net present value negative activity. With venture capital investing you can impact the outcome (i.e., change the odds) by having skill. You are also playing against other people not just the house. Professionals like Calacanis are investors since they actively impact the outcomes in a positive way by having a high degree of skill in sourcing, picking and helping founders make the business successful. Amateur Angel investors are in contrast to investors like Calacanis often gambling. One way for amateur Angel investors to improve their prospects is to get in the sidecar of a professional Angel investor, which can be accomplished through syndicates with a professional venture capital investor in the lead role.

Richard Zeckhauser in one of his classic papers entitled “Investing in the Unknown and Unknowable” describes the sidecar strategy:

“Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop real estate or new technologies. Those who lack these skills can look for ”sidecar” investments that allow them to put their money alongside that of people they know to be both capable and honest.

…Maxim A: Individuals with complementary skills enjoy great positive excess returns from Unknown and Unknowable investments. Make a sidecar investment alongside them when given the opportunity.”

The usual dozen lessons are below:

  1. “Poker is a real good analogy for angel investing because of implied odds.” “You have to bet, bet, bet with ice in your veins: knowing that after dozens of failures, you’ll hit a winning bet of epic proportions.” “We want 7 of 10 to fail because that means they are trying high-variance projects that have massive implied odds.”

David Sklansky writes in his book The Theory of Poker: “Implied odds are based on the possibility of winning money in later rounds over and above what is in the pot already. More precisely, your implied adds are the ratio of your total expected win when your card hits to the present cost of calling a bet.” Chamath Palihapitiya pointed out that the in a tweet: “Founders + VCs thrive on the implied odds from financings but don’t realize it also comes with reverse implied odds!” He links to this from a web site called The Poker Bank: “Reverse implied odds are the opposite of implied odds. With implied odds you estimate how much you expect to win after making a draw, but with reverse implied odds you estimate how much you expect to lose if you complete your draw but your opponent still holds a better hand.”

Regarding Poker and venture capital generally, Fred Wilson wrote the classic post:

“Early stage venture capital is a lot like poker.  The first round is the ante.  I think keeping the ante as low as possible is a good thing.  I like to think of it as an option to play in the next round and to see the cards.  Clearly, we don’t ante up to just any deal, but it is very useful to think of the first round as the ante. For the first year or 18 months, however long the first round lasts, you get to ‘see your cards’.  You learn a lot about your management team.  You learn a lot about the market you’ve chosen to go after.  You learn about the competition and a whole lot more. Then you have to decide whether to you want to see ‘the flop’, that is the next year to 18 months.  The price to see that is usually higher.  If you don’t like your cards (ie your management team, your market, the competitive dynamic, etc) then you fold.  Cut your losses.  Preserve your capital.  Wait for the next deal.”

 In an interview in San Jose Mercury-News venture capitalist Joe Lacob said about poker:

“No matter how much analysis you do, there’s always going to be things you don’t know. “And what makes somebody good at this business, vs. somebody not good, is the ability to take risk. Calculated risk. And to be OK with that. To be a gambler, to some extent. I like poker. I like the idea… of calculated risk. Doing my homework, and then you have to take a shot. You learn a lot in poker about people. Phil Hellmuth is a good friend of mine and you learn a lot about people when you play that game.”

  1. “I put $25k or $250k into a company and own one to five percent and most of them fail. So that one to five percent times is usually, 8 of 10 times, worth zero. Then one hand you kind of chop it. Then, hopefully, one hand out of 50 becomes Thumbtack or a Wealthfront. Then sometimes you hit the royal flush like Uber. I was the third or fourth person to invest in Uber and it only takes one of those to kind of make your career. Those are the equivalent of a 5,000 to 10,000 times return.”

What Angel investors accept in a business that has not proven either a value hypothesis or a growth hypothesis is far greater outcome variance due to convexity. Venture capitalists  hedge variance/convexity with a portfolio of bets and that is especially true at seed stage. All you can lose financially in venture capital is what you invest and your upside can be more than 1000X of what you invested. Why is an early stage opportunity to invest in a company like Lyft even available? Because most people like the safety of the herd and shy away from risk and uncertainty. Calacanis says:  “I have a theory about angel investing, which is basically you’re investing in the person and that the more outlandish the idea is, and the less people understand it, the greater the chances you should invest in it are.”

  1. “You have to get very comfortable with the concept of losing seven, eight, nine out of 10 bets.” “It’s very hard to sit down at a poker table or a blackjack table where you lose eight or nine out of 10 hands.” “You have to deal with bad news constantly. The companies that are failing take 10 to 50 times more of your energy and emotion and time than the winners. If you are emotionally not resilient, it is not the job for you. Every day, there’s three or four phone calls from founders that come in, or emails us, that they’re running out of money, they’re fighting with their co-founder, they’re being sued, somebody copied their idea, nothing’s working, the company’s sideways, they got hacked. It is a shit show most days. You have to have a certain desire to deal with insurmountable odds. You’ve got to have a little Han Solo in you, not C-3PO.”

Emotionally handling that the chaos that is an inevitable part of an Angel investor’s life is not an easy thing. When startups and businesses in a portfolio fail they are people you know. It can be both a grind and a struggle to do this work but it seems to be something that Calacanis is well suited for. Fred Wilson writes:

“In poker folding is simple.  In the VC business, it’s not that simple.  Sometimes you can fold by selling the company or the assets.  Other times, you need to shut the business down.  It’s not easy and many inexperienced VCs make the mistake of playing the hand out because they don’t want to face the pain of folding.  That’s a bad move.”

  1. “[Angel investing] is sort of like playing really bad cards with a very deep stack and seeing a lot cheap flops.” “As an angel you have to be able to focus on the 5% chance that things will go really, really well. As a VC you have to look at the downside a lot more because you make 1/20th the number of bets. I can put $25k into 30 companies a year and if I hit one big winner every 10 years I’m golden. VC doesn’t exactly work like that… you might do 20 investments over 10 years — if you were going fast!”  “There are probably 10,000 projects angel funded in technology per year (say 5x the number of venture deals per year, which I understand is around 2,000 here in the USA). If there are 10 angels in each deal (another guesstimate), that means 100,000 angel investments get put into this bucket per year. Over 10 years we have 1,000,000 swings at bat by angels. If we have 40 unicorns every 10 years here in the USA there are 400 angel lottery tickets (40 unicorns with 10 angels each) in the 1,000,000 lottery tickets issued. By this absurdly incorrect math, you would have  .04% chance of getting a lottery ticket: 1 in 2,500.’’ 

Marc Andreessen describes the approach of a venture capitalist as “buying a portfolio of long–dated, deeply–out-of-the-money call options.” Entrepreneurs are in the business of creating those call options and selling some of them to investors to create a pool of capital to fund the businesses. In evaluating each call option a venture capitalist is seeking a mispriced asset.  Half crazy ideas are typically more mispriced and have the convexity that venture investors need to generate grand slam financial outcomes.

There are only so many actual exits for investors. Creating a unicorn is not the same thing as getting a financial exit.

Venture

Venture backed

  1. “Angel investing is very similar to poker, where you’re playing against other people, you can increase your chances.” “The big rub in all this is that you have to get access to the unicorns as they are born.” “You can’t be ever embarrassed about hustling.”

Steven Christ writes: “The reason that you can win at poker [is that] you are not betting against the house; you are betting against the other players. This is such a crucial and fundamental difference, and it is lost on the general public. The house is not setting the odds. In roulette, there are 38 spaces on the wheel, and if you pick the correct one, the house will pay you off at 35-to-one, and they will keep the difference. The longer you play, the more you lose and the more the house wins. When the other players are setting the prices, it is an entirely different story…”

  1. “Why is there such an overlap between angel investor and poker player? It’s a couple of things. One, you’re dealing with partial information and trying to make decisions. You have to make a lot of decisions under pressure with money, exactly like investing. You’re under pressure, there’s time constraint, and you don’t have complete information. If you can have a slight edge in some way, you can outperform everybody else. It’s the same as investing. Also, deception, intimidation, reading people.”

One of the most creative thinkers ever to tackle the theory of poker was John von Neumann, a Hungarian born mathematician, physicist, inventor, computer scientist, and polymath. One biography notes that “…the inspiration for game theory was poker, a game he played occasionally and not terribly well. Von Neumann realized that poker was not guided by probability theory alone, as an unfortunate player who would use only probability theory would find out. Von Neumann wanted to formalize the idea of ‘bluffing,’ a strategy that is meant to deceive the other players and hide information from them.” The Financial Times elaborates:

“John von Neumann believed that if you wanted a theory that could explain life, you should start with a theory that could explain poker – game theory. “Real life consists of bluffing, of little tactics of deception, of asking yourself what is the other man going to think I mean to do, and that is what games are about in my theory.” High quality global journalism requires investment. It was the bluff that interested von Neumann. Novices wrongly believe that bluffing is merely a way to win pots with bad cards. In the 1972 final of the World Series, the famous hustler Amarillo Slim won because he had bluffed so often that when he finally put all his chips in the pot with a full house (a very strong hand), his opponent assumed Slim was bluffing again; called (matching the bet), and lost. A player who never bluffs will never win a big pot, because on the rare occasions that he raises the betting, everyone else will fold before committing much money. Then there’s the reverse bluff: acting weak when you are strong. In the 1988 World Series, the Chinese-born Johnny Chan (dubbed the “Orient Express” because he won money so quickly) passed up every opportunity to raise the stakes and meekly called his opponent’s bets. By the last round of betting, his opponent became convinced that Chan didn’t have a hand and bet everything he had. Chan called and turned over a straight – a strong hand – scooping up $700,000 and the title of world champion.”

  1. “I know I’m not smarter than Google. Me vs. a Google person playing chess I’d lose. Me vs. anybody at Google in poker, I’m rich; I will win. You have to know what game you’re playing. I would not play chess vs. anybody at Google or write an algorithm.”

One of the best ways to improve your poker results is to play against weak competition and to avoiding being the weak competition. This is essentially the circle of competence principle put to work in poker. The Poker Dictionary defines a few key terms relevant to circle of competence: “In the 1990s the bad players were referred to as fish. Nowadays they are called donkeys. A tournament that is full of donkeys or bad players is called a donkament.” Having some fish or donkeys in a card game wakes winning easier. Amarillo Slim said once: “No river, no fish.” A similar saying is: “You lead a horse to water, but a donkey will follow you all the way to the river.” Some people believe that a donkey is a bit different than a fish because fish are just prey and a donkey can have dumb luck and take your money.

  1. “Angel investing is gambling in the same way poker is: it involves a lot of skill and discipline on top of the luck.” 

In all questions that involve the relationship between investing and games the “go to” expert is Michael Mauboussin:

“Luck plays a huge role in determining results in investing, especially in the short term. Luck is also prominent in business strategy and card games —including blackjack and poker. One way to think about the difference between the results for pianists and poker players is to visualize a continuum with all luck at one end and all skill at the other. Then place activities along that continuum. Roulette wheels and lotteries are on the luck side, and swim and crew races are on the skill side. Most of the action in life sits between those extremes…. there’s no way to know for sure how Phil Ivey will fare in the next World Series of Poker because even if he plays his cards just right, he may suffer from awful luck.”

luck

  1. “If you’re at the poker table and you can’t tell who you’re better than and who the fish is, you’re the fish. That’s, inevitably, how everybody starts. What you have to do is try to slowly move yourself up.” 

An academic paper that looks at poker makes a point about poker that is a lot fancier but less informative.

“The results show that competitive edges attenuate as one moves up levels, and tight-aggressive strategies––which tend to be the most remunerative––become more prevalent. Further, payoffs for different combinations of cards, varies between levels, showing how strategic payoffs are derived from competitive interactions. Smaller-stakes players also have more difficulty appropriately weighting incentive structures with frequent small gains and occasional large losses. Consequently, the relationship between winning a large proportion of hands and profitability is negative, and is strongest in small-stakes games.”

  1. “It’s a portfolio strategy. If 7 out of 10 fail, 8 out of 10 fail, what you’re trying to do is figure out what those 2 out of 3. Let’s say 2 or 3 out of 10 don’t fail. You want to quickly figure out who those 2 out of 3 are, and then take your 25k investment and make a 100k investment in those 3. Then you figure out, let’s say you’ve done 100, and you have 4 of them that are really breaking out, you want to figure out which those 4 are, so you can put 250k into those. On a name basis, 7 out of 10 of your investments fail. Say you put 10k into each, that’s 70k gone. Then the last 3, let’s say you put 100k in each. Now, you have 300 active, and you put 100 into the first 10. 7 failed, so you have 330k of your 400k is still in play. You see what I did there? You do 10k in 10, 70 goes away, 30,000 is still active. You put 100k in each, now you’ve got 330k still active. Then, 2 of those sell off and you get your money back, fine, you’ve got 110 back. Great, you have 220 back of your 400 committed. Then, you put half a million into that one this really breaking out, and that half a million goes 20, 30, 50x. Holy shit, now you’ve got a $10 million or $25 million return on your hand, and you’ve played the game properly. You’re doubling down, and then you’re going all-in. It is just like poker. When you get pocket aces, or ace, king, or 10, jack suit, or whatever it is, you make an exploratory bet. When the flop comes and your 10, jack is met with ace, king, queen, you’re like, ‘Oh my God, these donkeys probably have ace, queen and ace, king. They’re going to be batting like maniacs, and I have the stone cold nuts right now.’” 

Fred Wilson writes about one important idea that Calacanis is talking about in this way: 

“If you structure your deals appropriately, you can often get three or four rounds.  As your hand strengthens, the cards get better, you increase the betting, putting more money at risk in each subsequent round.  That’s how smart poker players win and it’s also how smart VCs win. The poker analogy only works so far.  Bluffing doesn’t work in the VC business.  If you’ve got a band hand, you really can’t bluff your way out of it.  But on the other hand, you can impact the cards you’ve got.  You can work with management, beef it up, switch markets, buy some businesses, etc.  You can significantly improve your hand if you work at it, something that’s not really possible in poker.”

In a book entitled Venture Investing in Science Douglas Jamison and Stephen Waite argue:

Hiq

“What the heck are ‘the nuts’?” you might ask if you are not a poker player.  The origin story for that term goes like this:

“This poker term dates way back to the Wild West where cowboys would gather round a table, preferably in a saloon but alternatively around a campfire, and play cards. Back then poker players would not always bet with cash or chips. It was a more rustic time, and men would often bet their horse and wagon on a poker hand. Legend has it that when a cowboy bet his wagon he would unscrew the nuts from his wagon wheels and place them in the pot. The reason behind this gesture was that in the event that he lost the pot he could not leap up, hop into his wagon and ride away with his wager. The fact that he was willing to put those nuts in the pot as surety for the strength of his hand resonated through the prairie, and came to be synonymous with the best hand. A cowboy would only bet “the nuts” when he was convinced that his hand was the best out there.”

Bankroll management is an important part of Angel investing and poker. I wrote about this set of issues in my post on Ed Thorp. He is how one poker player manages his bankroll:

  1. “Poker, like entrepreneurship,  is very painful when you start, but then you get better at it.” 

Investing, poker and business are skills that you can get better at. Skill matters in poker and venture capital. Freakonomics author Steven Levitt with Thomas Miles did a study and concluded:

“…we analyze that question by examining the performance in the 2010 World Series of Poker of a group of poker players identified as being highly skilled prior to the start of the events. Those players identified a priori as being highly skilled achieved an average return on investment of over 30 percent, compared to a -15 percent for all other players. This large gap in returns is strong evidence in support of the idea that poker is a game of skill.”

Douglas Jamison and Stephen Waite argue:

smarter

  1. “Poker has a lot of things that entrepreneurship is about. Trying to figure out a situation with limited information.” “[Investing and poker] are very analogous and I think reading people is a skill of angel investors.  Reading people understanding people. Understanding motivation and then also trying to solve problems with limited information. When you look at poker you’re trying to uncover this riddle and you don’t have complete information.”  “Jason’s Law of Angel Investing” states: “You don’t need to know if the idea will succeed — just the person.” “Jason’s Second Law of Angel Investing” states: “Your success is correlated to the amount of time you give to founders.” “I have a theory about angel investing, which is basically you’re investing in the person and that the more outlandish the idea is, and the less people understand it, the greater the chances you should invest in it are.” “People who are crafts persons and who have craftsmanship in their work, they will always happen, whether in the early stage or late stage. When I see a particularly well-designed product, or somebody understands their metrics, I know that person cares. People are in this wacky belief system that their idea matters, when it does not. All that matters is what you build.”

This last item is obviously grab bag of quotes from Calacanis. In this collection of quotes you see his investing thesis come more into the light. These are a good way to end this post since it is getting a bit long. Calacanis proves that great investors hustle, have an extensive scuttlebutt network and read constantly.

Notes: 

Angel: How to Invest in Technology Startups-Timeless Advice from an Angel Investor Who Turned $100,000 into $100,000,000 https://www.amazon.com/Angel-Invest-Technology-Startups-Timeless-Investor/dp/0062560700

https://sites.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf

https://25iq.com/2016/10/01/a-dozen-things-you-can-learn-by-reading-the-success-equation-by-michael-mauboussin/

http://www.pokerlistings.com/angel-investor-jason-calacanis-poker-will-go-through-a-renaissance-75643

http://angellist.tumblr.com/post/141199140045/interview-with-jason-calacanis-investor-in-uber

https://www.recode.net/2017/4/12/15262830/transcript-podcaster-entrepreneur-angel-investor-jason-calacanis-recode-media

https://newslines.org/jason-calacanis/

http://calacanis.com/2015/01/09/should-you-be-an-angel-investor/

https://www.startupgrind.com/blog/from-the-vault-jason-calacanis/

http://avc.com/2004/11/the_poker_analo/

http://www.thepokerbank.com/strategy/mathematics/reverse-implied-odds/

https://www.cnbc.com/id/49791755

http://thelousylinguist.blogspot.com/2008/01/donkeys-and-fish.html

https://www.nber.org/papers/w17023

https://link.springer.com/article/10.1007/s10899-009-9168-2

https://www.linkedin.com/pulse/20130928204536-24171-the-end-of-venture-capital-sort-of

https://www.forbes.com/sites/jakehayman/2016/04/07/pokermeetsphilanthropy/#5d4f5226a63a

https://cs.stanford.edu/people/eroberts/courses/soco/projects/1998-99/game-theory/neumann.html

A Dozen Lessons about Business and Investing from Poker

 

You can’t write about the relationship between games and investing without quoting Michael Mauboussin. I will do so often in this post. He is the master. Read his books. All of them. Then read them again.

Set out below are the usual dozen lessons you can learn from poker:

  1. “Poker is a game where you don’t have to have the best hand to win. Poker is really reading other people and reading human emotion, which certainly comes into play in business.” Charlie Ergen 

One of the stories people tell about Charlie Ergen is how he was a blackjack card counter before he created the DISH satellite television business. One part of the lore about his poker playing is this anecdote:

“In 1980, a few months before Charlie Ergen co-founded the company that would become Dish Network, he and a gambling buddy strode into a Lake Tahoe casino with the intention of winning a fortune by counting cards. Ergen, then 27, had bought a book called Playing Blackjack as a Business and studied the cheat sheets. Unfortunately for him, a security guard caught his pal lip-syncing numbers as the cards were dealt. The two were kicked out and subsequently banned from the casino.”

Ergen knows the smartest business people and investors don’t really “gamble” (a net present value negative activity) since their intent is to bet only when the odds are substantially in their favor (i.e., a net present value activity). Ergen understands this distinction since he has the same outlook as Steve Crist of the Daily Racing form:

“A good litmus test for someone being a liar and an idiot is if someone ever tells you, ‘I am really good at roulette,’ or ‘I win at craps,” or ‘I have a system for beating the slot machines.’ There is no such thing. These are games with fixed percentages. The casino might as well attach a leach to your forehead when you walk in the door because the longer you stay, the more you will lose, except for short-term, meaningless fluctuations. The exceptions to [the previous] rule are blackjack and poker. If you count cards diligently in blackjack, you can get a 1.5 percent edge over the house. Casinos, of course, don’t get built by players having edges, so the casinos will eject you if they figure out that you’re counting cards.”

The best example of what essentially was poker playing I have even seen in business is how Bill Gates managed Microsoft’s relationship with IBM and took them to the cleaners. Gates said in 1993:

“We would have been glad at sometime to sell IBM part of the company. We even proposed to IBM that they buy part of Microsoft– I think it was 30%– and they turned us down. At every stage of our relationship, they had project groups doing work to wipe us out. We stayed ahead, but it wasn’t simple.” Computerworld, May 24

This story has never been properly told.  If someone does write an accurate account someday, it will convey poker playing skills at the highest level. The relationship wasn’t just a dumb lumbering IBM not understanding software (although there were elements of that). IBM was actively engaged in a campaign to “wipe out” Microsoft. Gates played hand after hand against IBM in this business poker game and won every time. The OS/2 era alone is worthy of an entire master class in business strategy.

2. “If there weren’t luck involved, I would win every time.” Phil Hellmuth

There is no substitute for a sound process in an activity like investing. When playing poker you can make a wise decision and still lose or make a terrible decision and still win. As Michael Mauboussin writes: “If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions and rely less on the short-term outcomes. The reason is that luck breaks the direct link between skill and results—you can be skillful and have a poor outcome and unskillful and have a good outcome. A good process can lead to a bad outcome in the real world, just as a bad process can lead to a good outcome. In other words, both good and bad luck can play a part in investing results. But the best investors and business people understand that over time a sound process will outperform.” Over a shorter period  of time, luck can fool you into believing that someone has skill or good judgement. On this point I have always liked this 1993 quote from Bill Gates on luck: “The notion that people who have been lucky enough to make a lot of money know something or are worth listening to is a risky proposition.” Chicago Tribune, October 24.

Luck of course is at the root of what poker players calls a bad beat. There are many stories one of them is:

poker

3. “On any given day a good investor or a good poker player can lose money.” David Einhorn 

Mauboussin tells this story about poker:Jim Rutt, who used to be the CEO of Network Solutions. He talked about playing poker when he was a young man.By day, he would learn about the different probabilities, and look for poker tells and pot odds, and all this stuff, and by night he would play. He played in progressively tougher games, and won some, lost a little. Eventually, his uncle pulled him aside and said, “Jim, it’s time to be less worried about getting better, and more worried about finding easy games.”

Mauboussin tells another story to illustrates this point:

“[A baseball executive] was in Las Vegas sitting next to a guy who has got a 17. So the dealer is asking for hits and everybody knows the standard in blackjack is that you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the man’s hand, right, and the dealer sort of smiles and says, “Nice hit, sir?”  Well, you’re thinking nice hit if you’re the casino, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves. In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.”

  1. “Ain’t only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself. Any donkey knows that.”  Puggy Pearson

This statement from Puggy Pearson is one of the favorite quotes of Michael Mauboussin who wrote one of his many essays specifically on Pearson.” In that essay Mauboussin explain’s what Pearsin means:

“Pearson’s message may be colloquial, but that in no way undermines its power. We can express the ideas more formally, and readily draw out critical investment concepts. Taken together, Pearson’s points indeed provide a strong foundation for investment success. The core of Pearson’s point is that investors should seek financial opportunities that have a positive expected value. A positive expected value opportunity has an anticipated benefit that exceeds the cost, including the opportunity cost of capital. Not all such financial opportunities deliver positive returns, but, over time, a portfolio of them will. So how should investors seek such opportunities? First off, investors must understand their source of competitive advantage. Markets reflect the collective expectations of investors, and embody more information than any individual can hope to have. An investor with a competitive advantage knows something that the market doesn’t—based either on superior information or on superior analysis of known information. An investment is attractive if it trades below its expected value. Expected value, in turn, is a function of potential value outcomes and the probability of each outcome coming to pass. Investing is fundamentally a probabilistic exercise, and leading investors always think in probability terms. In Pearson’s words: ‘I believe in logics. Cut and dried. Two and two ain’t nothing in this world but four. But them suckers always think it’s somethin’ different. I play percentages in everything.’ Investing is the constant search for asymmetric payoffs, where the upside opportunity exceeds the downside risk. Ben Graham described margin of safety as buying an investment for less than what it is worth. The larger the discount, the greater the margin of safety. That’s knowing the 60-40 end of a proposition.”

My blog post last weekend on Ed Thorp has loads of great material on the Kelly criterion. I win’t repeat that here other than to repeat two sentences from Thorp which make the key points: “If you bet too much you’re likely to be wiped out. If you bet too little it takes forever to make any money, so there’s a happy medium.”

  1. “Coming out ahead at poker requires that I win a lot on my winning hands and lose less on my losers. But insisting that I’ll never play anything but ‘the nuts’ – the hand that can’t possibly be beat – will keep me from playing lots of hands that have a good chance to win but aren’t sure things.  For a real-life example, Oaktree has always emphasized default avoidance as the route to outperformance in high yield bonds. Thus our default rate has consistently averaged just 1/3 of the universe default rate, and our risk-adjusted return has beaten the indices. But if we had insisted on – and designed compensation to demand – zero defaults, I’m sure we would have been too risk averse and our performance wouldn’t have been as good. As my partner Sheldon Stone puts it, ‘If you don’t have any defaults, you’re taking too little risk.’” Howard Marks

My blog posts on Howard Marks are here and here.  In his book Margin of Safety, Seth Klarman writes:

“Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.” 

Sometimes the right result is found through trial an error. At other times intelligence and observation are the key factors. There is also luck involved of course and a keen understanding of human nature. In their famous book In Search of Excellence Tom Peters and Bob Waterman write:

“There is a quality in experimentation as a corporate mind set that resembles nothing so much as a game of stud poker. With each card, the stakes get higher and with each card, you know more, but you never really know enough until the last card has been played. The most important ability in the game is knowing when to fold.”

As an example of business people making big bets, here are Bill Gates and Steve Jobs talking about a big bet made by Apple and a simultaneous big bet by Microsoft:

“Bill: One of the most fun things we did was the Macintosh and that was so risky. People may not remember that Apple really bet the company. Lisa hadn’t done that well, and some people were saying that general approach wasn’t good, but the team that Steve built even within the company to pursue that, even some days it felt a little ahead of its time–I don’t know if you remember that Twiggy disk drive and…

Steve: 128K.

Bill: The team that was assembled there to do the Macintosh was a very committed team. And there was an equivalent team on our side that just got totally focused on this activity. Jeff Harbers, a lot of incredible people. And we had really bet our future on the Macintosh being successful, and then, hopefully, graphics interfaces in general being successful, but first and foremost, the thing that would popularize that being the Macintosh….We made this bet that the paradigm shift would be graphics interface and, in particular, that the Macintosh would make that happen with 128K of memory, 22K of which was for the screen buffer, 14K was for the operating system.

Steve: What’s interesting, what’s hard to remember now is that Microsoft wasn’t in the applications business then. They took a big bet on the Mac because this is how they got into the apps business. Lotus dominated the apps business on the PC back then.”

  1. “It’s very important for most people to know when not to make a bet, because if you’re going to come to the poker table, you’re going to have to beat me, and you’re going to have to beat those who take money. So, the nature of investing is that a very small percentage of the people take money, essentially, in that poker game, away from other people who don’t know when prices go up whether that means it’s a good investment or if it’s a more expensive investment.” Ray Dalio

Many people agree with these points made by Dalio, including these three famously successful people:

Warren Buffett: “The important thing is to keep playing, to play against weak opponents and to play for big stakes.” “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

Charlie Munger: “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” Charlie Munger was once asked who he was most thankful for in all his life. He answered that he was as most thankful for his wife Nancy’s previous husband.  When asked why this was true he said:  “Because he was a drunk. You need to make sure the competition is weak.”

Tony Hseih of Zappos: “An experienced player can make ten times as much money sitting at a table with nine mediocre players who are tired and have a lot of chips compared with sitting at a table with nine really good players who are focused and don’t have that many chips in front of them. In business, one of the most important decisions for an entrepreneur or a CEO to make is what business to be in. It doesn’t matter how flawlessly a business is executed if it’s the wrong business or if it’s in too small a market.”

  1. “One of the best antidotes to this folly is a good poker skill learned young. The teaching value of poker demonstrates that not all effective teaching occurs on a standard academic path.” “Part of what you must learn is how to handle mistakes and new facts that change the odds. Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much loved hand.” “Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.” “And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It’s just that simple.” Charlie Munger 

A simple point Munger makes again and again is that understanding probability and statistics is essential in both card playing and investing. Munger bets big when he sees a situation that is “net present value positive” over time after fees and expenses. Bets that are net present value negative are avoided. Amarillo Slim has a view that is similar to Munger: “I like to bet on anything—as long as the odds are in my favor….there are people who love action and others who love money. The first group is called suckers, and the second is called professional gamblers, and it was a cinch which one I wanted to be.” Here’s a story about Slim putting that principle to work:

“Bobby Riggs, the 1939 Wimbledon Tennis Champion tried to hustle Amarillo Slim in Ping Pong. Riggs was looking to bust Slim’s skinny ass. Slim tells the story, “I told Riggs I would play him in Ping Pong straight up with one stipulation: that I got to choose the paddles. “We both use the same paddle?” Bobby asked. “Yessir.” “So when you show up with two of the same paddles, can I get my choice of which one of them?” “Yessir, so long as I can bring the paddles.” Bobby thought I was pulling a schoolboy’s scam—that it was a weight thing or that one of the paddles was hollow or something. But once I told him that he could choose whichever of the two paddles he wanted to use, he couldn’t post his money fast enough. We bet $10,000 and agreed to play at two o’clock the next day. Before I left, just to avoid any misunderstanding, I confirmed the bet: We were to play a game of Ping Pong to twenty-one, each using the paddles of my choosing. I showed up the next day at the Bel Air Country Club ready to wage battle. When Bobby asked to see the paddles, I reached into my satchel and handed him two skillets, the exact same weight and size, and told him he could use either one. Now, Bobby was about as coordinated an athlete that ever lived, but he was swinging that skillet like a fry cook on speed. It wasn’t until I had him buried that he started to get the hand of that skillet, but it wasn’t soon enough. I won the game 21-8, and it could have been much worse. Once again I proved that you can make a living beating a champion just by using your head instead of your ass. The easiest person in the world to hustle is a hustler, and Bobby had taken the bait like a country hog after town slop. You see, I had been practicing with that skillet since I saw him in Houston.”

  1. “Poker is a lot like sex, everyone thinks they are the best, but most people don’t have a clue what they are doing.” Dutch Boyd

Overconfidence is one of many behavioral biases that can trip up a poker player or investor. Charlie Munger likes to use this example to explain this bias: “A careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives.” Munger is talking about investing here but he may as well have been writing about poker: “The primary problem with this bias is that people who should be buying index funds think they can be successful active investors. Munger has said: “Most people who try don’t do well at it. But the trouble is that if even 90 percent are no good, everyone looks around and says, ‘I’m the 10 percent.’”

  1. “In poker, a player collects different pieces of information—who’s betting boldly, what cards are showing, what this guy’s pattern of betting and bluffing is—and then crunches all that data together to devise a plan for his own hand.” Bill Gates

When Bill Gates was a student at Harvard people he went to school with quickly found out how hard he works to learn and how persistent he can be:

“He took up poker with a vengeance. The games would last all night in one of the common rooms of Currier House, which became known as the Poker Room. His game of choice was Seven Card Stud, high low. A thousand dollars or more could be won or lost per night. Gates was better at assessing the cards than in reading the thoughts of his fellow players. “Bill had a monomaniacal quality,” Braiterman said. “He would focus on something and really stick with it.” At one point he gave Paul Allen his checkbook to try to stop himself from squandering more money, but he soon demanded it back. “He was getting some costly lessons in bluffing,” said Allen. “He’d win $300 one night and lose $600 the next. As Bill dropped thousands that fall, he kept telling me, ‘I’m getting better.’ ” He was known to be an aggressive player,” says C. Greg Nelson ‘75. “But in the crowd at Currier House where we played, he was about the median—definitely not in the top quartile.” According to Nelson, the group usually played with six people and allowed participants to buy into the game for $100. As the year went on, the pot would grow until some hands were being played for over $1,000.”

Gates is also very practical. When the Altair computer came out Gates “decided that I better buy one.  I thought it was a better use of my money than losing at poker.” The process did have some significant befits according to Steve Ballmer who has said that Microsoft’s success in business was “basically an extension of the all-night poker games Bill and I used to play back at Harvard. Sometimes whole divisions would get moved just because someone bet two pairs against an inside straight.  People were always wondering why [co-president] Jim Allchin ended up with so much power. What can I say? He bet big and won big.”

The pattern recognition and bluffing part of poker is fascinating. Tom Schneider, a four-time World Series of Poker bracelet winner once said:

“I pick up clues immediately. If you come in, and all your bills are 20s, it means you don’t have casino chips and you don’t have 100s. It means you went to the bank, and money is probably more important to you. You’ll be a little tighter with it than somebody who comes in with $20,000 in $5,000 casino chips, which means they’re probably a gambler in the pit and money won’t mean as much to them.”

But poker requires skills that transcend simply knowing the odds of completing any particular hand. It requires a split-screen ability to read the other people at the table while maintaining an awareness of how they are reading you. It requires what is called “leveling”: the ability to move fluidly and accurately in one’s imagination from the hands that all the other players are representing, to the hands that they probably have, to the hand that they think you have, to the hand that they think that you think that they think you have. The acute awareness and processing ability required to quickly go through a complex checklist and get it right—while controlling your thoughts and behavior so that others can’t read you with any equivalent degree of accuracy—is what separates poker pros from casino operators and other crude types who profit from the fact that large numbers of people are dumb or drunk and can’t do math.”

The number of possible “tells” that can potentially be exploited in poker is gigantic:

“Because poker is a game of human interaction, we sometimes receive clues from other players, based on changes in their betting patterns or their physical demeanor, which indicates the strength or weakness of their hand. These are called “poker tells.” A player gains an advantage if he observes and understands the meaning of another player’s tell, particularly if the poker tell is unconscious and reliable. Sometimes a player may even fake a tell, hoping to induce his opponents to make poor judgments in response to the false poker tell. After all, poker is a game of deception. Poker tells come in two forms: (1) Betting patterns and (2) Physical tells.”

  1. “Nobody is always a winner, and anybody who says he is, is either a liar or doesn’t play poker.” “The over-under, is just another example of how the bookmakers are always looking for more options to give the guesser an opportunity.”  Amarillo Slim

Charlie Munger’s best essay and arguably the one that made him most famous is entitled:  “A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management and Business” and it can be found here.  In this wonderful essay is a long passage which includes this language:

“The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack… Everybody goes there and bets and the odds change based on what’s bet.  That’s what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal….”

My essay on Steve Crist discusses the meaning of this point so I won’t repeat that here.

  1. “If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.” Peter Lynch

If you are going to win at poker you need to have an edge of some kind. That means doing things like acquiring skill and finding better information.  Howard Marks writes: “The investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the great the likelihood you can learn things others don’t.” In addition to having an informational edge, outlook is important. Poker professional Doyle Brunson once said: “Poker is not a game where the meek shall inherit the earth.” If you don’t do the work, understand probability, manage your bankroll well, manage your emotions and understand the emotions of others, you are going to get your clock cleaned in poker and in business.

Somtimes the best way to learn the importance of something is to go without it as an experiment. This link tells a story about a famous player winning without looking at their cards:

  1. “This fricking donkey stuffs $15,000 in with king-jack. I mean, the guy can’t even spell poker.”  Phil Hellmuth

Humans love stories and part of the fun of playing poker is the ability of a player to tell a story like Hellmuth just did. Business for me is the same way. Part of the fun of this blog is telling stories. A great story told well is one of the best ways ever invented to teach people about a topic. Before the invention of written language stories were the only way that culture and history were conveyed from generation to generation. As an example, I edited two books of stories collected by my Great Grandfather Judge Arthur Griffin that he used to help establish native American treaty rights since there was no other written record that they could use to make their case. The best business people and founders are great story tellers. Some of the best story tellers like Mark Twain were also poker fans as was the great sportswriter Grantland Rice. Twain once said: “There are few things that are so unpardonably neglected in our country as poker. Rice said it better: “It’s not whether you won or lost, but how many bad-beat stories you were able to tell.

Maybe the best way to end this post is with a Puggy Pearson story. It is sort of long (about six minutes) and you will probably enjoy it most if you are a poker player:

Notes:

Bill Gates at Harvard: http://news.harvard.edu/gazette/story/2013/09/dawn-of-a-revolution/

Charlie Ergen: http://www.hollywoodreporter.com/news/dish-networks-charlie-ergen-is-432288

Mauboussin on Puggy Pearson: https://www.scribd.com/document/112879396/Puggy-Pearson-s-Prescription

My Steven Crist post https://25iq.com/2016/05/21/a-dozen-things-ive-learned-from-steven-crist-about-investing-and-handicapping-horses/

Einhorn http://www.thinkingpoker.net/

Mauboussin:    https://research-doc.credit-suisse.com/docView?language=ENG&format=PDF&sourceid=em&document_id=x745112&serialid=knrGGNw%2Bo620toTTx96qBQ%3D%3D

Poker tells:

https://www.washingtonpost.com/blogs/local/wp/2014/04/23/what-professional-players-see-at-the-poker-table-hint-more-than-you/?utm_term=.d39b899b9538

http://www.pokerology.com/lessons/poker-tells/

https://www.pokernews.com/news/2009/03/pokernews-top-ten-big-event-bad-beats-1285.htm

http://tournamentpoker.weebly.com/1/category/famous%20poker%20stories/1.html

A Dozen Lessons on Investing from Ed Thorp

“Edward O Thorp is the author of Beat the Dealer, which was the first book to prove mathematically that blackjack could be beaten by card counting, and Beat the Market, which showed how warrant option markets could be priced and beaten. He also was the co-inventor of the first wearable computer along with Claude Shannon. Thorp also pioneered the use of quantitative investment techniques in the financial markets (Option Arbitrage, Warrant Modeling, Convertible Arbitrage, Index Arbitrage and Statistical Arbitrage).”  

Thorp speaks clearly and from the heart. He reminds me of that other ultra rational decision maker Charlie Munger. Despite his prodigious intellectual gifts Thorp remains grounded and approachable. A few sentences reveals his gift for communication which reminds me of Michael Mauboussin:

“My life has been an adventurous journey I thought readers would enjoy my stories of the people I met and the challenges I faced.” “Chance can be thought of as the cards you are dealt in life. Choice is how you play them.” “A lot of big choices that you make at some point or other, and then there are things that you can’t control like who your parents were, and what kind of economic circumstances you were brought up in, where you started. Did you start 20 yards behind the start line or 20 yards ahead of it, or right on it? People start in different places. Those are cards that are dealt.”

Set out below are usual twelve lessons I have learned from Thorp:

  1. “Try to figure out what your skill set is and apply that to the markets. If you are really good at accounting, you might be good as a value investor. If you are strong in computers and math, you might do best with a quantitative approach.” “If you aren’t going to be a professional investor, just index.”

Thorp likes to stay within his circle of competence. This is a hallmark of people who are rational. In that sense, Thorp reminds me of Warren Buffett. But unlike Buffett, Thorp did not make his fortune in the market by analyzing businesses and instead found his special competency in statistical arbitrage, which he more or less invented. Thorp was able to successfully take his considerable mathematical and intellectual gifts and apply them in an area where he has a significant advantage.

  1. “The way I sized up the Ben Graham approach was that it would be a total lifetime of effort. It was all I would be doing. Warren demonstrated that. He’s the champion of champions. But if I could go back and trade places with Warren, would I do it? No. I didn’t find visiting companies something I wanted to do. I never even thought about finance until I was 32.”

Thorp also decided early in life to get in the side car of other people who have a different competitive advantage. He invested in Berkshire when the stock was trading at $982 and still hold those shares today. When Buffett was winding up his partnership he was asked to do some due diligence on Thorp as an investor by a mutual friend. That chain of events resulted in Thorp and his wife playing bridge with Buffett in 1968. Thorp described the meeting: “The Gerards invited my wife Vivian and I to dinner with Warren and his charming blonde wife Susie.  Impressed by Warren’s mind and his methods, as well as how far he’d already come, I told Vivian that he would eventually become the richest man in America.  A mutual friend talked recently with Warren, who spoke warmly of our meetings, of Beat the Dealer and Beat the Market, and of non-transitive dice.”

Speaking of impressive mental calculation, Barry Ritholz recently interviewed Thorp and watched him calculate his return on his Berkshire shares in his head. Thorp is the sort of person who taught himself FORTRAN so he would create his card counting techniques for Blackjack on an IBM 704 mainframe. The number of things Thorp taught himself is astounding.

It is a good thing to remember that you are not Ed Thorp, Warren Buffett or Charlie Munger and neither and I. If you have similar mathematical gifts as Ed Thorp or Buffett, good for you. I do not have them. Even if you have those mathematical gifts, are you are rational as Thorp? Do you have control of your ego sufficiently to stay within your circle of competence?

  1. “The first group of investors are those who do not want to do a lot of work who should invest in indexes. Index investors do better than maybe 90% of all other investors who are busy paying fees to advisers.” “The second group are those who would like to learn more about securities. They are entertained by following and analyzing securities. I think they can learn about special, unusual things although there is a price for that education. [They are] interested in the market, and it’s kind of fun for them. Those people if they want to learn more should go out and have their go at trying to make some money, but they shouldn’t use the bulk of their resources to do this. If they find something that really works then they can start putting more money into it. They’ll find that most of the time they haven’t really found anything that really works.” “The third group, which are the professional people some of whom actually get an edge. Most of whom don’t, but some of whom do. Those people get a start somehow in the market just like I got a start with an option’s formula, so I have an edge. I get in. I build an organization, which is small, and it gradually grows. It gets more and more skills. It gets into more and more kinds of investing. You, basically, get over the hurdle and get yourself established. If you can do that as a professional then you’re kind of on your way to collecting what people call Alpha, excess return. Then there’s the fourth group, which I don’t have much interest in, and those are the ones who are simply asset gatherers. They’re in there to collect fees and get rich, but there’s nothing really very interesting in what they do.” 

In which category do you fit? Do you enjoy learning a lot about businesses? Are you willing to devote many hours a day to researching businesses? Have you tried picking stocks with a small portion of your assets and carefully tracked results to see if you are any good at it?

  1. “[Slot machines are] the most moronic devices ever, one of the stupidest activities of humankind. People play negative-expectation games. That’s something I’m not willing to do. I’ve never even bought a lottery ticket.” “The first thing people who have control do is tilt the playing field. Maybe the majority of wealth is accumulated because of tilted playing fields. Not because of merit.” “In standard gambling games in casinos you can generally calculate what the casino’s edge is, or if you figure out how to count cards you can calculate what your edge over the casino is. It’s a fact, a mathematical fact, that if you play a game like this and the casino has the edge it will eventually collect all your money if you play long enough. On the other hand, if you have an edge your bankroll will grow and grow and grow. Basically, what happens is your bankroll either grows or shrinks depending on what your edge is or what your disadvantage is. There’s luck that pushes it up and down around that growth curve. That’s the way things look in the gambling world.”

If you look carefully at what Thorp has accomplished with his funds he was not gambling if you define it as a “negative net present value” activity (which you should). Thorp only invested when he had a statically generated advantage or as he calls it “an edge.” I have never bought a lottery ticket either. I would rather drop a large rock on my toe than gamble.

  1. “The overlap of interest between gambling and the stock market is very high. There are so many similarities and so much one can teach you about the other. Actually, gambling can teach you more about the stock market than the other way around. Gambling provides an analytically simpler world, and you can see principles and test theories.” “I chose to investigate blackjack.” “I was lucky in that I came at investments through blackjack tables. And the blackjack tables are an amazingly good training ground for learning how to invest, how to think about investments, how to manage them. And the reason is that they teach you, on the one hand, to use probability and statistics to evaluate things. And on the other, they teach you discipline. When you find something, you stick to it. “Most of the games, whatever happens on one trial or one play of the game doesn’t have any influence on what’s going to happen next. I realized that in a minute or two that if cards were used up during the play of the game, the odds would shift back and forth – sometimes for the casino, sometimes for me.” “Say a blackjack player is dealt a ten and a six, while the dealer’s showing a ten. You can calculate that situation, and anyone who’s played any cards knows you’re ‘supposed’ to hit. But what if your 16 is comprised of two fours and four twos? In a deck that’s ten rich, it’s a definite stand.” “Beating the blackjack tables by keeping track of the cards was, though I didn’t realize it until later, a preparation without equal for successful investing.  When I had the edge, I bet big, but not so big as to risk going broke. When the cards favored the casino, I played defense, to limit my losses. The same approach worked on Wall Street: the bigger my edge, the more I bet and the greater the risk the more cautious I was. Gambling and investing are alike – in both you risk money, which you then may win or lose.”

Again, the comparison to the methods of Charlie Munger is easy. Munger has said: “Life in part is like a poker game, wherein you have to learn to quit sometimes when holding a much loved hand….Playing poker in the Army and as a young lawyer honed my business skills … What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often.”

  1. “One of the early things that I learned, fortunately, which was how much to bet on good situations. If you bet too much you’re likely to be wiped out. If you bet too little it takes forever to make any money, so there’s a happy medium.” “You have to make sure that you don’t over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss — but never more. If you bet much more you can be ruined, even if you have a favorable situation. It’s a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge.” “There are, however, safer paths that have smaller draw downs and a lower probability of ruin. If you bet half the Kelly amount, you get about three-quarters of the return with half the volatility.  I believe that betting half Kelly is psychologically much better…. sometimes the dealer will cheat me. So the probabilities are a little different from what I calculated because there may be something else going on in the game that is outside my calculations. Now go to Wall Street. We are not able to calculate exact probabilities in the first place. In addition, there are things that are going on that are not part of one’s knowledge at the time that affect the probabilities. So you need to scale back to a certain extent because over betting is really punishing—you get both a lower growth rate and much higher variability. Therefore, something like half Kelly is probably a prudent starting point. Then you might increase from there if you are more certain about the probabilities and decrease if you are less sure about the probabilities.” “In the last 15 years or so, there has been a large flow of capital into the hedge-fund world, from $100 billion in the early 1990s to $2 trillion now. But the amount of available investing opportunities hasn’t increased that much. That has led to the over-betting phenomenon [which can result in] gambler’s ruin.” 

I remember when I first started reading about the Kelly criterion in books and essays written by Robert Hagstrom and Michael Mauboussin. It was a revelation. Imagine how cool it would have been to be a fly on the wall when Thorp and Claude Shannon were having conversations at MIT. Or learning and debating with Richard Feynman. Thorp has had such an interesting life, but the idea of he and Shannon developing the world’s first wearable computer to beat casinos at roulette is Ocean’s Eleven type stuff. In a paper detailing the shenanigans Thorp writes:

“The final operating version was tested in Shannon’s basement home lab in June of 1961.  The cigarette pack sized analog device yielded an expected gain of +44% when betting on the most favored “octant.” The Shannons and Thorps tested the computer in Las Vegas in the summer of 1961.  The predictions there were consistent with the laboratory expected gain of 44% but a minor hardware problem deferred sustained serious betting. We kept the method and the existence of the computer secret until 1966.”

Thorp was smart and rational enough to have avoided the gambler’s ruin that caught Long Term Capital Management. Elliot Turner describes a talk Thorp gave at Sante Fe Institute:

“Thorp described their strategy as the anti-Kelly.  The problem with LTCM, per Thorp, was that the LTCM crew ‘thought Kelly made no sense.’  The LTCM strategy was based on mean reversion, not capital growth, and most importantly, while Kelly was able to generate returns using no leverage, LTCM was ‘levering up substantially in order to pick up nickels in front of a bulldozer.’”

Turner also notes: “It’s been mentioned that both Warren Buffett and Charlie Munger discussed Kelly with Thorp and used it in their own investment process.”

  1. “I think inefficiencies are there for the finding, but they are fairly hard to find.” “Markets are mostly good at predicting outcomes, but very bad at anticipating black-swan events.” “When people talk about efficient markets they think it’s a property of the market, but I think that’s not the way to look at it. The market is a process that goes on, and we have depending on who we are different degrees of knowledge about different parts of that process.” 

Thorp’s track record as an investor makes a mockery of anyone who believes in the hard version of the efficient market hypothesis. Elliot Turner gives summary of Torp’s approach and results as a hedge fund manager:

“In 1974, Thorp started a hedge fund called Princeton/Newport Partners [which] used warrants and derivatives in situations where they had deviated from the underlying security’s value.  Each wager was an independent wager, and all other exposures, like betas, currencies and interest rates were hedged to market neutrality. Princeton/Newport earned 15.8% annualized over its lifetime, with a 4.3% standard deviation, while the market earned 10.1% annualized with a 17.3% standard deviation (both numbers adjusted for dividends).  The returns were great on an absolute basis, but phenomenal on a risk-adjusted basis.  Over its 230 months of operation, money was made in 227 months, and lost in only 3.” 

  1. “When the interests of the salesmen and promoters differ from those of the client, the client had better look out for himself.” 

Thorp knows that you should never ask a barber if you need a haircut. There are few things as powerful in human affairs as incentives. Both at a personal level and in society as a whole, incentives are the dominant cause of outcomes. The more you understand the impact of incentives, the more you understand life.

  1. “When there’s money and not full accountability, whether it’s in casinos or on Wall Street, there’s going to be stealing and cheating.” “My book tells how you have to be aware of cheating in both of these worlds.  At blackjack, it can be marked cards, second-dealing, or a stacked deck.  On Wall Street, it can be Ponzi schemes and other frauds, such as insider trading, fake news, or stock price manipulation. Mathematically, the biggest difference is that the odds can be figured exactly or approximately for most gambling games, whereas the numbers are usually far less certain in the securities markets.”

Munger not surprisingly agrees with Thorp: “Where you have complexity, by nature you can have fraud and mistakes. The cash register did more for human morality than the Congregational Church. It was a really powerful phenomenon to make an economic system work better, just as, in reverse, a system that can be easily defrauded ruins a civilization.One of the reasons Thorp uses a fractional Kelly approach is that it provides some protection against fraud.

  1. “Most stock-picking stories, advice and recommendations are completely worthless.” “Sell down to the sleeping point. As far as asset classes go, it is hard to know when you are in a bubble, and if you are in one, when it will pop.” “I read a good book recently, Superforecasting by Dan Gardner and Philip Tetlock. They wanted to see whether people can forecast better than chance. What they found is that experts often do not have much to tell us things of value. Experts receive a lot of media attention because they make strong, definite claims. But definitive claims are usually not accurate predictions; we can only see the future fuzzily. People that tend to weigh different possibilities can make somewhat better predictions than chance.”

The most effective way to learn this lesson is the same way you learn not to touch a hot stove as a child. But the better way is to watch someone else do it. “Just say no” to stock tips. Bernard Baruch described why stock tops are so appealing to some people in this way:

“Beware of barbers, beauticians, waiters – of anyone – bringing gifts of ‘inside’ information or ‘tips’.  The longer I operated in Wall Street the more distrustful I became of tips and ‘inside’ information of every kind. Given time, I believe that inside information can break the Bank of England or the United States Treasury.  A man with no special pipeline of information will study the economic facts of a situation and will act coldly on that basis. Give the same man inside information and he feels himself so much smarter than other people that he will disregard the most evident facts.”

  1. “People say, ‘Gee, what if your Berkshire goes down?’ I say, ‘Oh, that’s good because now I can buy more’” They say, ‘But what if it goes up?’ I say, ‘Well, that’s good too because I feel good because I feel suddenly richer.’ So let it go up or let it go down. I don’t care.”  

This statement by Thorp is a variant of a point Warren Buffett likes to make:

“This is the one thing I can never understand. To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the “Hallelujah Chorus” in the Buffett household.  When hamburgers go up, we weep. For most people, it’s the same way with everything in life they will be buying–except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”

P.s.,

  1. At the 2017 Daily Journal of Commerce annual meeting Charlie Munger recommended Thorp’s autobiography A Man For All Markets. Thorp tells this story about attending a Berkshire meeting in Omaha:

“Saturday night we were back at Gorat’s! The price of the T-bone dinner we had Friday was, as a “special for shareholders,” now $3 more! Charlie Munger reluctantly ‘worked’ the room we were in and I mentioned to him a tale I’d heard about his youth. Charlie had gone to Harvard Law School and, when a friend of mine got his degree there a few years later, he found that Charlie was a legend – with many saying he was the smartest person ever to have attended.  As a first year student Charlie was said to have regularly intimidated professors in the classroom.  While autographing my menu, Charlie said (perhaps sadly) ‘That was a long time ago … a long time ago.'”

2. “Warren Buffett once challenged Bill Gates to a game of dice. ‘Buffett suggested that each of them choose one of the dice, then discard the other two. They would bet on who would roll the higher number most often. Buffett offered to let Gates pick his die first. This suggestion instantly aroused Gates’ curiosity. He asked to examine the dice, after which he demanded that Buffett choose first.” Buffett was using a set of non-transitive dice! An explanation of these dice is here: https://www.microsoft.com/en-us/research/project/non-transitive-dice/

“From “Fortune’s Formula”, by William Poundstone 2005:

“The dean of UC Irvine’s graduate school, Ralph Gerard, happened to be a relative of legendary value investor Benjamin Graham. Gerard was then looking for a place to put his money because his current manager was closing down his partnership. Before commiting any money to Thorp, Gerard wanted his money manager to meet Thorp and size him up.  “The manager was Warren Buffett. Thorp and wife [Vivian] met Buffett and wife for a night of bridge at the Buffetts’ home in Emerald Bay, a community a little down the coast from Irvine. Thorp was impressed with Buffett’s breadth of interests. They hit it off when Buffett mentioned nontransitive dice, an interest of Thorp’s. These are a mathematical curiosity, a type of “trick” dice that confound most people’s ideas about probability.”

 

Notes:

http://tech.mit.edu/archives/VOL_081/TECH_V081_S0000_P001.pdf

http://www.cs.columbia.edu/~feiner/courses/mobwear/resources/thorp-iswc98.pdf

https://c.mql5.com/forextsd/forum/102/berkshire_hathaway.pdf

http://compoundingmyinterests.com/compounding-the-blog/2012/10/12/how-did-ed-thorp-win-in-blackjack-and-the-stock-market.html

http://www.latimes.com/business/hiltzik/la-fi-hiltzik-thorp-20170217-story.html

https://www.ft.com/content/e7898528-e897-11e6-967b-c88452263daf

http://ritholtz.com/2017/07/mib-ed-thorp-beat-vegas-wallst/

http://www.npr.org/sections/money/2017/01/13/509624455/the-house-always-wins-then-he-came-along

http://www.npr.org/templates/story/story.php?storyId=123209339

http://www.npr.org/templates/transcript/transcript.php?storyId=510810752

https://www.forbes.com/sites/prestonpysh/2017/03/13/edward-thorp-blackjack-beat-the-dealer/2/#6ecc2f6d30a2

http://www.timmelvin.com/a-conversaation-with-ed-thorp/

https://www.forbes.com/sites/johnnavin/2017/01/06/the-new-book-by-the-math-professor-who-beat-las-vegas-wall-street/#7e81fc3b9130

http://fortune.com/2016/12/24/ed-thorp-stock-markets-investing/

http://www.pmjar.com/wp-content/uploads/2013/05/Size-Matters-Mauboussin.pdf

https://www.fool.com/investing/2017/01/26/the-riveting-story-of-edward-thorp.aspx

http://mebfaber.com/2017/02/08/10017/

https://www.forbes.com/sites/johnnavin/2017/01/06/the-new-book-by-the-math-professor-who-beat-las-vegas-wall-street/#3f31970eb913

 

 

 

Amazon Prime and other Subscription Businesses: How do you Value a Subscriber?

 

Businesses increasingly don’t just sell products and services in a single transaction. Subscription and other businesses that focus on recurring sales have existed for a very long time. What is new is that many more businesses have adopted a subscription approach, which makes them look a lot more like a company in the the cable television business than an auto parts manufacturer.

Successfully implementing a subscription business model can be particularly hard since the customer acquisition cost (CAC) happens up front and the revenue appears over time. These subscription businesses have a revenue profile that is more like an annuity. This revenue profile is not like the manufacturer’s business that many people learned about from a college introduction to accounting class. Unlike an annuity, the revenue stream of a subscription business is subject to risk, uncertainty and ignorance. The good news is that it is precisely because there is risk, uncertainty and ignorance that an opportunity for profit exists. The bad news is that it can be hard to capture. The reality is that if you do not capture this profit your competitors may do so.

Someone may ask: Why should I worry about this? Will it be on the test? The answer is: Yes and yes. Charlie Munger says it best: “The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.” The text in bold in the Munger statement is critical with a subscription service like Amazon Prime- you can’t understand the value of the business by looking at just one month or even a few months since it is lifetime value that matters.

Why are these new subscription businesses being created more often? The economics of a subscription business can be very favorable if you get it right. A lot of financial leverage can be generated if the customer does not need to be acquired repeatedly. Customer acquisition cost is lower for a well-run subscription business even though it is more front loaded. Yes, subscription business models can have more predictable revenues, but that is not caused by the tooth fairy. More predictable revenues are a byproduct of lower overall CAC and some operational approaches and investments in customer retention. The trade-off is that a subscription business model can also be deadly if you get it wrong. Each of the key variables in a subscription business can be either: (1) many angels working together to build something wonderful, or (2) a pack of hungry wolves that can tear the business to shreds. Propelling more businesses to adopt a subscription business  model is a simple truth: if your competitors or competitors get this model right your business may be doomed.

The benefits of this new way of doing business was chronicled well in the book The Outsiders by Thorndike. One of the major innovators of this way of doing business model was John Malone in the cable television industry. Here is John Malone talking about the model he used to build many of his businesses:

“We decided… to go on a cash flow metric very much like real estate. Levered cash flow growth became the mantra out here. A number of our eastern competitors early on were still large industrial companies — Westinghouse, GE, — and they were on an earnings metric. It became obvious to us that if you were going to be measured on earnings, it would be real tough to stay in the cable industry and grow.” “I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite. That’s why the cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.” “It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings..” “The first thing you do is make sure you have enough juice to survive and you don’t have any credit issues that are going to bite you in the near term, and that you’ve thought about how you manage your way through those issues.” “I used to go to shareholder meetings and someone would ask about earnings, and I’d say, ‘I think you’re in the wrong meeting.’ That’s the wrong metric. In fact, in the cable industry, if you start generating earnings that means you’ve stopped growing and the government is now participating in what otherwise should be your growth metric.”

The more you understand about what John Malone has accomplished in his business the more you will understand what companies like Amazon are doing in their business.

To help entrepreneurs, shareholders and lenders understand whether a given business is generating what Charlie Munger called “more value in terms of discounted future cash-flow than it is paying for” it is more than useful to calculate what is known as “unit economics.” I have written a post before about unit economics, but in this blog post I focus more on examples.

Bill Gurley sets the stage:

“[Understanding] the actual unit economics in the underlying business…requires analyzing the ‘true’ contribution margin of the business; not simply looking at gross or net revenue and the proper contra-revenue treatment, and not even looking just at gross margin as defined by the company. Many companies embed costs that are truly variable (for instance customer support, marketing, credit card processing) below the gross margin line. If you want to know if the business model truly hunts, you must pay careful attention. Otherwise, you may have simply found a company that is simply selling dollars for $0.85.”

These five factors determine the “unit economics” of a business:

  1. a customer acquisition cost (CAC);
  2. an average revenue per user (ARPU);
  3. a gross margin;
  4. a customer lifetime (which is a function of customer retention/churn); and
  5. a discount rate.

Let’s work though a key sensitivity using a fictional example. Imagine there is a business with the name “Green Oven” that delivers the food components for cooking meals along with recipes (i.e., food Legos for adults).  Assume Green Oven’s unit economics look like this:

Average revenue per user (ARPU) per month – $110

Gross margin – 33%

Monthly customer churn – 18%

Customer acquisition cost (CAC) – $450

Discount rate – 10%

The lifetime value of a Green Oven Customer would look like this:

LTV prime

That set of numbers above obviously produces an ugly lifetime value. What would happen to Green Oven’s unit economics if the rate of customer churn could be reduced to 7% a month?

LTV1

Making this comparison (often called a sensitivity analysis) reveals that retention is an important factor for Green Oven. Another important sensitivity to model is the impact of a lower customer acquisition cost (CAC). Let’s take it down to $300 and assume churn is 10% in another sensitivity calculation. The numbers look like this:

LTV2

It is useful to play around with a lifetime value spreadsheet and do numerous sensitivity runs to get a “feel” for how the variables interact in a given business. In this case of the Green Oven the high CAC makes high churn a potential business killer. Green Oven needs to be laser focused on reducing CAC, so it can better handle churn.

When a business reports an input into lifetime value like CAC or churn it is often an average. That may hide the fact that there are big differences in the analysis by “cohort.” A cohort is a collection of customers who share an attribute or set of attributes. For example, one type of a cohort is those customers who subscribed to a service in a given month.

Managing customer lifetime value for a business isn’t simple as David Skok writes:

“If you’re an early stage SaaS startup, still trying to get product/market fit, or experimenting with different ways to make your marketing and sales predictably repeatable and scalable, it is useful to play around with CAC and LTV to get a feel for where you are. But it’s important to note that these formulae will only yield meaningful results when your sales and marketing process and costs are predictable and scalable. Instead of spending too much time obsessing over CAC and LTV, rather focus your energies on solving the problems of improving product market fit, and making your customer acquisition, repeatable, scalable and profitable.

My apologies that there are some complex looking formulae in this article. We have provided a summary below of the key concepts, and a link to jump straight to the spreadsheet to model your own LTV. For those interested in understanding the theory behind this model, we provide our usual detailed explanation below.”

Making management of lifetime value is hard for an entrepreneur in no small part because the lifetime value variables change based on other factors like the sales channel used or geographic factors. A business can start out with very high CAC and then have it it drop over time (XM Sirius or Netflix) or have relatively low CAC and watch it rises over time (Blue Apron it appears). You can see the impact of these changes yourself by using Skok’s spreadsheet in the link to perform your own sensitivity analysis.

Why might CAC drop? There are many possible reasons including improved core product value over time, less competition, a booming economy and rising incomes, or a better sales funnel. Spending money on a growth hypothesis before a value hypothesis is a classic way to suffer horrific churn. Nothing reduces churn more than a more delighted customer.  Nothing makes it worse the an unhappy customer telling other people about their unhappiness.

  1. “If the dogs don’t want to eat the dog food, then what good is attracting a lot of dogs?” Andy Rachleff
  2. “If you make customers unhappy in the physical world, they might each tell 6 friends. If you make customers unhappy on the Internet, they can each tell 6,000 friends.” Jeff Bezos
  3. “The key is to set realistic customer expectations, and then not to just meet them, but to exceed them – preferably in unexpected and helpful ways.” Richard Branson

Why might CAC rise? There are many reasons this could happen including but not limited to greater competition, a recession, or the need to move into new market segments as the early mark segments become fully penetrated. Amy Gallo writes in a Harvard Business Review article:

“Often a high churn rate is the result of poor customer acquisition efforts. “Many firms are attracting the wrong kinds of customers. We see this in industries that promote price heavily up front. They attract deal seekers who then leave quickly when they find a better deal with another company…Before you assume you have a retention problem, consider whether you have an acquisition problem instead.” “Think about the customers you want to serve up front and focus on acquiring the right customers. The goal is to bring in and keep customers who you can provide value to and who are valuable to you.”

A cohort analysis might look like this when graphically presented (another David Skok example):

cohort

In the title of this blog post I said that I would explain how to value an Amazon Prime Subscriber. If you think about Amazon Prime as an annuity (i.e., in terms of lifetime value) it might look like this below:

AMZN PRIME

This LTV calculation for Amazon Prime is based on one set of assumptions by one analyst based on incomplete information. The assumptions for Prime used by this analyst are:

ARPU: $193 a month

SAC: $312

Gross margin 29%

Churn  0.6% (customer life 167 months or ~14 years)

Discount rate 9%

You can use your own variables and David Shok’s spreadsheet (or your own) in conducting a lifetime value analysis rather than relying on Cowen. Not looking at lifetime value at all is a huge mistake. A company like Amazon is not understandable if you believe its business model is similar to the steel manufacturer you learned about in your introduction to accounting class. Trying to value Amazon’s Prime business with a P/E ratio is like trying to open a can of corn with a pickle.

An investor can pretend they do not need to do this lifetime value math, but the result will not be pleasant. Peter Lynch famously said that an investor who does not do research is like a poker player who does not look at the cards. To understand the value of the stock of a company that is using a subscription business model you need to understand the business and you can’t understand a business like Amazon without doing this lifetime value math. I will be writing more on subscription business models in subsequent blog posts.

Notes:

Bill Gurley  http://abovethecrowd.com/2015/02/25/investors-beware/

David Skok: http://www.forentrepreneurs.com/ltv/

Amy Gallo: https://hbr.org/2014/10/the-value-of-keeping-the-right-customers

My blog post on the book The Outsiders: https://25iq.com/2014/05/26/a-dozen-things-ive-learned-about-great-ceos-from-the-outsiders-written-by-william-thorndike/

My previous post on Unit Economics: https://25iq.com/2016/12/31/a-half-dozen-ways-to-look-at-the-unit-economics-of-a-business/.

My previous post on CAC: https://25iq.com/2016/12/09/why-is-customer-acquisition-cost-cac-like-a-belly-button/

My previous post on churn: https://25iq.com/2017/01/27/everyone-poops-and-has-customer-churn-and-a-dozen-notes/

A few links

On churn:

https://www.ngdata.com/what-is-customer-retention/

https://hbr.org/2014/10/the-value-of-keeping-the-right-customers

On “Green Oven” comps:

https://www.linkedin.com/pulse/detailed-look-blue-aprons-challenging-unit-economics-daniel-mccarthy

https://medium.com/@nbt/how-blue-apron-compares-to-other-subscriptions-in-one-graph-6404a74ccf2d

https://medium.com/startup-traction/blue-apron-s-1-meals-on-your-doorstep-923499bcaf45

http://www.slate.com/blogs/business_insider/2017/06/30/blue_apron_customer_retention_low.html

How to Create a Successful Business Model in a Dozen Easy Steps [Fake advice! Not possible.]

 

You can’t create a successful business model in a dozen easy steps. The title of this blog post is fake news or, more accurately, fake advice. This blog post will give you real advice instead.

Successful business models can be created with a lot of hard work, creativity, innovation and especially experimentation, but there are no formulas. Fortunately there are best practices. I have written about business models many times before (for example, my Steve Blank and Eric Ries posts), but in this post I will be making my points more with examples than the usual more narrative explanation.

The best place to start is asking what a business model is and how it is best discovered. The best place to start is with a definition. I like the Mike Maples Jr. definition: “The way that a business converts innovation into economic value.” Steve Blank has his own definition that is also useful: “A business model describes how your company creates, delivers and captures value.” In other words a business must create value within the value chain and it must capture some of that value. Sometimes value is created and delivered by an entrepreneur and yet little or no value is captured by the creator. As an example, Spotify is creating lot of value in its value chain but how much value is it capturing?  The important point is that a business model that does not capture value is not a successful business model. The concept of “capturing value” particularly important since it requires some sort of competitive advantage.  The most common cause of failure is the failure of a business model to have a competitive advantage. In a recent interview Bill Gurley described one critical objective of a business in this way: “What is it that will allow you to protect that business over the long term? That could be a network effect. It could be some kind of scale advantage. But it needs to have something like that.” In the Floodgate Value Stack model I have written about before this is the third layer which they call Business Model Power:

value stack

A business model is discovered rather than precisely planned in advance and then manufactured. A flywheel is often used as a metaphor for this because the business model discovery and maintenance process is based on iteration and feedback. The “build measure learn” process is a feedback loop that never ends as long as the business is in operation. Businesses that stop the business model improvement and maintenance process inevitably die. A paper by Rita McGrath notes:

“In highly uncertain, complex and fast-moving environments, strategies are as much about insight, rapid experimentation and evolutionary learning as they are about the traditional skills of planning and rock-ribbed execution. Modeling, therefore, is a useful approach to figuring out a strategy, as it suggests experimentation, prototyping and a job that is never quite finished.”

Sometimes the discovery process is quick and sometimes it is slow. Sometimes the business model discovery process creates a successful outcome, but very often it does not. Applying the scientific method to the business model discovery process is a proven way to improve and expedite business model discovery. As I said I want this post to be more about illustrative examples than usual, so let’s dive into that process. I decided to pick an example from the early 1990s. Many people have forgotten or do not know that at this time people had no clue about many of the business models that would eventually be created. The big buzz was around the Information Superhighway and services built around television. People might say: “I would have known what was about to happen to business models in the years after 1993.” The answer to that is: “No you wouldn’t.” Businesses whose success seems obvious now did not seem so than. Some of the smartest and best informed people in the world missed these successes completely. Some people got a few things right obviously but even then their views and plans evolved over the years based on feedback. The future in the 1990s and all other periods was discovered rather than predicted. People made a lot of bets in the 1990s and some of them worked out. Some people were better at making bets than others. Some of that was luck and some of that was hard work, perseverance and skill.

One of the best illustrative example of my points is Starwave, a business founded in 1993 which pioneered a number of important internet technologies and business models. The founder of Starwave was my friend Mike Slade, who once said: “The whole concept of Starwave was to take various bets on the future of a wired world.” At that time the “wired world” was the investing thesis of Paul Allen who was Starwave’s primary shareholder. Allen once described his thesis as follows: “We can already see a future where high-bandwidth access to information is cheap, where there is plenty of computing power to manipulate that information, and where most of us are connected. I think the most exciting things happening have to do with content. We have only begun to invent what will be possible.” Wired magazine described this using the hyperbole that typified its writing at the time: “Starwave’s mission is to envision products and services as if bandwidth were infinite and free – in other words, as if there were no technological and financial limits to how titles and services could be produced and delivered.” Slade has described the “wired world” thesis in very practical terms: “Paul’s idea was that the world is going to be connected and we should do something about it.”

The magazine Fast Company described how Starwave’s business was evolved by Slade over the years:

“To their first brainstorming session with Allen, Slade brought eight ideas. The first stemmed from a job he had while in college. Back then, he wanted to be a sportswriter. Working at the local newspaper in the fall of his senior year, Slade would spend hours combing the Associated Press wire for stories and scores. After graduating in 1979, however, Slade changed his mind about sports writing. He pursued an MBA at Stanford and landed a job at Microsoft. But he never forgot those nights reading the sports wire, unencumbered by the limits of a sports section’s page count. ‘I always wanted to do that again,’ Slade said. ‘Everybody should like what I like, right? Of all the things that I could be a proxy for consumer taste on, being a sports fan is one. That was our first idea. We had a bunch of others. But of course the first idea was the best idea. Never fails. Off we went to do things with it.’

Trouble was, they still hadn’t come to terms with a platform. They created a few titles on CD-ROM. That’s the path down which most of the sports world was headed. All the leagues were licensing discs that included stats, video and audio that could be updated online, through dial-up modems. They built a few prototypes for an online site that would be delivered via interactive TV. None of it seemed to lead anywhere. For about nine months, Slade and a staff of almost 100 tweaked and tuned this thing that would deliver a sports wire feed, supplemented and complemented by original content, to home computers. They started negotiating with ESPN about branding it. But they couldn’t figure out how to get ‘it’ to sports fans. ‘We were all dressed up,’ Slade said, ‘with no place to go.’

Frustrated by the holdup, one engineer finally suggested that they put the product on the Internet. More specifically, on the World Wide Web. Slade knew the Web, knew it cold. He had been vice president of marketing for NeXT computers, the company Steve Jobs started after leaving Apple in 1985. The Web was created on a NeXT machine. Slade did not think the Web was the answer. It was ‘nerdy,’ Slade thought, and would never catch on beyond the scientists who used it to share their work. It wasn’t going to be a business. And it certainly wasn’t going to be a business until more people had high-speed connections. The engineer insisted they should do it anyway. Lacking a better plan of his own, Slade took the idea to Allen. “I went to Paul and said, ‘We’re going to build this thing on the World Wide Web, because we don’t know what else to do,’ Slade said, recounting the dialogue. ‘He goes, ‘What’s the business model?’ I go, ‘I have no idea.’ He goes, ‘OK.’”

This is classic example of an entrepreneur who knew that he needed to find “core product value” and “product/market fit” before finalizing the business model. Certainly all  possibilities were considered such as advertising, subscriptions, licensing, and merchandise, but nothing was set at the beginning of the process. Slade would later say: “There is no single plan or model for doing business on the Web because there is no business — yet.” He added on another occasion: “Our strategy was to get out ahead. And run like hell.”

Eventually at least several business models would emerge.  Most importantly Starwave cut a deal with ESPN that included:

“Placement of the ESPNet Sportszone name on the crawl that it would run at the 28- and 58-minute marks of every hour. Glover presented a rate card that showed Starwave was getting most of its money back in advertising on ESPN. In the deal analysis, Allen valued that as zero. ‘I have no idea what this is worth,’ he told Slade. Few did. ‘Turns out it was worth everything,’ Slade said. ‘The first people to run a crawl of a Web site that you were supposed to go to was us and ESPN.’ They made their debut on April 1 with an event at the Final Four in Seattle. Digger Phelps chatted up Allen at the launch party. Starwave gave out 15,000 browser discs at an ESPN booth at the convention center. Starwave never turned a profit on ESPN during the five years of the deal, but it became the bridge toward a larger relationship with Disney, which eventually bought Starwave. Along the way, the two companies charted a course for dot-com success.

It didn’t always proceed smoothly. The first time ESPN tried to sell advertising space on the site, the pitch tanked. Glover went to companies offering six charter sponsorship positions for $1 million each. For that, they’d get … well, to be honest, Glover hadn’t a clue. ‘We were laughed out of the room,’ Glover said. ‘Here, most people haven’t even heard of the Internet. And we wanted $1 million. Needless to say, we didn’t even get close to a sale.’ They did finally sell what some say was the first sponsorship deal on the Internet, to Gatorade, for $25,000. ‘And that was huge,’ Glover said. With the sports ubersite launched, Starwave and ESPN had a template in place. They would pay to develop and operate sports sites, in exchange for a cut of the revenue they brought in. They offered the same deal to each of the four major leagues and to NASCAR.”

To close this blog post it is worth thinking about is happening when a new business model is created. Nick Hanauer and Eric Beinhocker make important points here:

“A capitalist economy is best understood as an evolutionary system, constantly creating and trying out new solutions to problems in a similar way to how evolution works in nature. Some solutions are ‘fitter’ than others. The fittest survive and propagate. The unfit die. The great economist Joseph Schumpeter called this evolutionary process “creative destruction.” And he highlighted the importance of risk-taking entrepreneurs to make it work. Thus, the entrepreneur’s principal contribution to the prosperity of a society is an idea that solves a problem. These ideas are then turned into the products and services that we consume, and the sum of those solutions ultimately represents the prosperity of that society. Capitalism’s great power in creating prosperity comes from the evolutionary way in which it encourages individuals to explore the almost infinite space of potential solutions to human problems, and then scale up and propagate ideas that work, and scale down or discard those that don’t. Understanding prosperity as solutions, and capitalism as an evolutionary problem-solving system, clarifies why it is the most effective social technology ever devised for creating rising standards of living…. If the true measure of the prosperity of a society is the availability of solutions to human problems, then growth cannot simply be measured by changes in GDP. Rather, growth must be a measure of the rate at which new solutions to human problems become available.”

P.s., There are many other examples of business model discovery. The paper by Rita McGrath cited once before above (link in the notes) uses Google to make her points:

“Consider a business model category that we take for granted today – advertising-supported Internet searches. Text-based searching has been with us for decades, used primarily by organizations (such as libraries and police departments) equipped with electronic databases. When the Internet began to expand the amount of information available on line, new entrants promised a more organized way for users to find what they were looking for. The business model most early entrants tried was to be paid for the search itself, assuming that was what customers valued. In an early example (circa 1995), Infoseek tried to get customers to subscribe $9.95 per month for access to its search engines. Only later did players such as Yahoo! come up with the innovative idea of giving searches away for free in exchange for giving advertisers access to their visitors – and only later still did Google invent what is still regarded as the best algorithm for ranking web pages among the major search engines, creating a critical mass of searchers that would be attractive enough to advertisers to delivers the huge profits it enjoys today.

Without disparaging Google’s accomplishments in any way, its current success stems from and builds upon the many previous experimental efforts made by preceding companies. Figure 2 illustrates how the experimental process of discovering a viable business model for Internet searching unfolded over a considerable time. Note that the model shifted conceptually as technological possibilities expanded e from transaction to subscription based models, to ones supported by advertising. And note also how the advertising-supported model gives a first-mover advantage to a firm that is able to achieve critical mass, since it becomes more attractive to both searchers and thus advertisers. 

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Notes:

My post on Steve Blank: https://25iq.com/2014/10/18/a-dozen-things-ive-learned-from-steve-blank-about-startups/

My Post on Eric Ries:  https://25iq.com/2014/09/28/a-dozen-things-ive-learned-from-eric-ries-about-lean-startups-lattice-of-mental-models-in-vc/

The Mouse that Roared https://na01.safelinks.protection.outlook.com/?url=http%3A%2F%2Fwww.sportsbusinessdaily.com%2FJournal%2FIssues%2F2008%2F03%2F20080310%2FSBJ-In-Depth%2FThe-Mouse-That-Roared.aspx%3Fhl%3DEdge%2520Marketing%26sc%3D0&data=02%7C01%7Ctgriffin%40microsoft.com%7C914a8a5af4174750993908d4be6dce47%7C72f988bf86f141af91ab2d7cd011db47%7C1%7C0%7C636342826203706034&sdata=sMa%2FXVWuvKYyH9hNZmRKAJDSGm%2F0LQZ%2FgMgayUeNGdU%3D&reserved=0

Starwave Takes the Web https://na01.safelinks.protection.outlook.com/?url=https%3A%2F%2Fwww.fastcompany.com%2F27448%2Fstarwave-takes-web-seriously&data=02%7C01%7Ctgriffin%40microsoft.com%7C914a8a5af4174750993908d4be6dce47%7C72f988bf86f141af91ab2d7cd011db47%7C1%7C0%7C636342826203706034&sdata=wDbFQg22UXC3w6vV5LtJDceT66qWW%2B6OhSetnZ0p%2Fr4%3D&reserved=0

Rita McGrath paper: https://pdfs.semanticscholar.org/3f08/b47c049a84fb440caaf6ee3a44c0af4e3fef.pdf

 

A Dozen Things I’ve Learned About Startups from Hunter Walk

 

Hunter Walk is a partner at the seed stage venture capital firm Homebrew Management, which he co-founded in 2013. He previously was head of consumer product management at YouTube. Walk joined Google in 2003 managing product and sales for their contextual advertising business. He was a founding member of the product and marketing team at Linden Lab, the creators of online virtual world Second Life. Earlier in his career he was a management consultant and also spent a year at Late Night with Conan O’ Brien. He has a BA in History from Vassar and an MBA from Stanford University.

 

1. “The best businesses are being constructed by founders who have empathy for, or a connection to the problem they’re solving. It’s not about disdain for an industry. We like to see founders who have a real connection to the problem that goes beyond excitement about a market opportunity. Founders need a ‘why’ that is very personal.” “When founders have an empathetic understanding of a market and they are connected to the problems they are solving, it’s a more ‘mature’ approach to a starting a startup.”

While it would seem natural for people to understand the importance of “product/founder fit,” startups are often created by people who do not have a passion or connection to the problem they are trying to solve. Why would anyone start a business they are not passionate about? Well, they may have read that the block chain was a big opportunity or thought that virtual reality was an attractive market and concluded that they should start a business take advantage of those opportunities. What a venture capitalist like Walk wants is an emotional connection to the customer problem. Mark Zuckerberg is an example of a founder with deep understanding of the company’s product and a strong vision on where he wants the company to go. Bill Gates and Steve Jobs both had this same set of qualities. Great chief executives inevitably have help that allows them to focus on being a great CEO. Zuckerberg has Sheryl Sandberg to focus on operating the business which makes him a better CEO. My friend Craig McCaw had John Stanton and Jim Barksdale as managers to do many of the things that Sandberg does.

There are lots of great examples demonstrating why not considering product/founder fit can be a huge mistake. Steve Blank talks about his own experience with this set of issues here:

“I was now a CEO of Rocket Science, and having a great time building the company. Unfortunately, while I had gone through phases of video game addiction in my life, in no way could I be described as even a “moderate hard-core gamer,” which ruled me out as a domain expert. I realized that for the first time in my career I had no emotional connection to my customers or channel partners. I was about 90 days into the company when I began to realize there was something very different about this business. In previous companies I could talk about technology details and how the product features could solve a customer problem. But people didn’t buy video games on features and they weren’t looking to solve a problem. I was in a very, very different business. I was in the entertainment business. There couldn’t have been a worse choice for CEO in Silicon Valley. Alarm bell one should have started ringing – for me and my board.”

A deep understanding of and empathy for the problems faced by the customer and the market increases the probability that the business will find a way to successfully deliver core product value (solve a real customer problems that they are willing to pay for). A founder of a startup needs every advantage they can get given the struggle that are going to go through. There is a reason why so many people call building a business from startup a “grind.” Perseverance is an essential attribute in a founder.

2. “Don’t start a tech company just because you ‘want to do a startup.’ Startups are hard! You have to be mission-driven. Be able to understand the ‘why?’ Why do you want to spend, minimally, several years of your life working on a particular problem? If you’ve personally experienced the problem you’re solving, or are connected to it in some meaningful way, you’re more likely to persevere and adapt through the challenges of starting a company.”

Startups are hard. As Ben Horowitz wrote in his book The Hard Thing about Hard Things, the effort to create a successful business is inevitably a series of struggles. The passion that the founders and early employees have for the customer problem will energize and sustain them through the struggles that a startup must conquer to be successful. People who love what they do create, make and sell better products. This idea applies in life generally and not just in startups. Warren Buffett puts it this way: “You really should take a job that if you were independently wealthy that would be the job you would take. You will learn something, you will be excited about, and you will jump out of bed. You can’t miss.”

Why are startups so hard? As Charlie Munger says, if business and investing were easy everyone would be rich. The unfortunate reality is that in an economy there is always a top- down constraint on the amount of profit that can be earned in the aggregate by all businesses. Yes, the size of the pie can get bigger for everyone if an economy is healthy and innovation is taking place, but statistically we have data that shows that there is a top-down constraint to how quickly that can happen. There are many venture capital firms trying hard to increase the size of the pie and that is quite exciting, but we have a ways to go before we see the results of these efforts. One of the best posts on this issue was written by Fred Wilson and is entitled: “The Venture Capital Math Problem.” It would be great if someone solved this math problem Wilson talks about via innovation and growth but it is not something that we can say has already been proven to have happened.

What do I mean by top-down constraint? Understanding this concept is best conveyed by example. Warren Buffett said something once about a single company that I am going to change to be about a cohort of collections of startups:

Think about a cohort of startups with a combined market cap of $500 billion. To justify this price, they would have to collectively earn $50 billion every year until perpetuity, assuming a 10% discount rate. And if the businesses do not begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years, $66.5 billion. Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion. It would require a rather extraordinary change in profitability to justify that price.

To put the magnitude of a cohort generating $50 billion in new earnings in context:

top 10

New businesses with profits that approximate those generated by a business like Apple, Microsoft, Google and Facebook do not arrive that often. People and organizations have only so much money to spend and competition effectively creates a top down limit on profit. In addition, much of human progress in consumer surplus and generates no profit or even less profit. The economy does not have an unlimited ability to generate new profits to support the income needed by a very large business like Facebook or Google that often. That ability to support new profit streams can be changed in positive ways via innovation and investment, but the historical record is that that power of an economy to absorb new businesses that deliver huge profits to shareholders does not just radically leap ahead. I would be as happy as anyone if this did happen, but some realism about how much the aggregate profit in an economy can scale over a limited period of time is wise. Fred Wilson points out that venture capital is only a small part of the private equity asset class because it has scaling challenges. Venture capital does punch far above its weight in terms of societal benefit, but there are limits to venture capital ecosystem growth that no one has found a solution for yet. My heart is hopeful, but my brain is more cautious.

3. “Write your principles in pen but your strategy in pencil.”

“What is Strategy?” is the title of a famous Michael Porter essay. Porter describes the essence of strategy in a few sentences:

“In many companies strategy is built around the value proposition, which is the demand side of the equation. But …it’s [also] about the supply side.” “If there are no barriers to entry…you won’t be very profitable.” “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.” “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different.” “The essence of strategy is choosing what not to do.” “Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.”

Almost anything a business creates and sells can be quickly copied by other businesses and as a result profit will be driven down by competition to the opportunity cost of capital. This is straight up college freshman economics. Increased supply is the killer of value. In other words, without some constraint on supply, price will drop to a point where there is no real profit left. That is why there is so much talk about “sustainable competitive advantage” by people who are actually running a business. People who believe all you need to do to be successful in business is to “make the trains run on time” make me giggle. Creating a sustainable competitive advantage is both rare and hard. Even if you have it you can lose it in a heartbeat. When sustainable competitive advantage is lost by a business it often can be traced to a mistake made five years before.

Regarding the “principles” of a business that Walk should be written in pen Charlie Munger believes: “Firms should have the ethical gumption to police themselves: Every company ought to have a long list of things that are beneath it even though they are perfectly legal. We believe there should be a huge area between everything you should do and everything you can do without getting into legal trouble. I don’t think you should come anywhere near that line.” The bonus says Munger: “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich–who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich–in money–not just in reputation.”

4. ‘There’s a big difference in-between ‘smart iteration’ and ‘lack of discipline.’” “Companies which raise too much too early might think they’re de-risking their funding but also may intro a host of other issues.”

“All work and no play makes Jack a dull boy” is a well-known proverb. “All iteration and no discipline will kill Jack’s startup” could also be a proverb. Long-time observers of the startup world often make this same point by saying: “More businesses die from indigestion than starvation.” A pivot is a stomach wrenching shift that should never be undertaken lightly. Similarly, wild goose chases into new areas of business can divert attention for the critical path. Too much cash can be bad for children, adults and startups. It causes people to do silly things. Buffett puts it this way: “Nothing sedates rationality like large doses of effortless money.”

5. “People tend to forget that your company is your first product, and you have to be intentional about building your company before it’s ready to really grow and scale.”

Walk make a a great point here about the importance of people and hiring. The best way to see if someone understands this point is to watch what they do and not what they say. Benchmark Capital’s Bruce Dunlevie is more focused on the strength of the team in a startup than any venture capitalist I have ever met. His sterling record as an investor is proof that his approach can have a huge payoff financially. His close friend Andy Rachleff believes: “When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.” The team you build is the business you build. Being especially intentional about how you build your team is wise.

6. “The only decisions that are reliably bad are those made out of fear.”

If you don’t feel some fear it is a clue that you may be dead. This is a more common condition that some people imagine. It is one thing to be conscious of fear, but quite another to make decisions based on fear. Dale Carnegie said once: “Inaction breeds doubt and fear. Action breeds confidence and courage. If you want to conquer fear, do not sit home and think about it. Go out and get busy.” Not only does refusing to let fear drive your decisions cause you to make better decisions, it makes you happier.

7. “Work with smart people you trust. Over-index to the quality and ethics of your coworkers and you’ll never go wrong. Not only does it increase the likelihood of success on current projects, but those are the type of people who will continue to work at amazing companies over the course of their careers.”

A “seamless web of deserved trust” is one of the biggest advantages a business can have. Trust is vastly more efficient than layers of management and control. Unfortunately, a system based on trust only works if you hire people very carefully. In other words, with great trust comes great responsibility to hire well. That someone is smart, hardworking and successful does not mean that they are trustworthy. Charlie Munger sets out the challenge on this set of issues:

“It’s hard to judge the combination of character and intelligence and other things. It’s not at all simple, which explains why we have so many divorces. Think about how much people know about the person they marry, yet so many break up. It’s not easy, but it is in some cases. If people are splashing around with money like Dennis Kozlowski, with vodka at parties coming out of some body part, and if it looks like Sodom and Gomorrah, then maybe this isn’t what you’re looking for. But beyond that, it’s hard. If you have some unfortunate experiences while getting that knowledge, well, welcome to the human race.”

If you have found you have made a mistake about someone’s character, then change course.

8. “Your organizational culture — especially as it relates to diversity — is established the moment you start a company. Once your team grows, once you have your first twenty employees, it’s very difficult to change a culture. Early hires are your culture.”

What is the culture of a business? I view it as a system of beliefs, mental models, values and principles that drive the behavior and actions of the people who are involved in a business. The best cultures are authentic in every sense. When people know what to do and actually do that when no one is looking at them, a healthy functional culture in place. Culture, like trust, allows the business to be more efficient. It also create a a shared sense of mission that breeds the missionaries that create successful businesses.

9. “The importance of adding an outside investor to your board as early as seed stage is more common now than it was when we started the fund early in 2013, there’s still occasional question about whether this slows down a company’s operations or gives investors too much control. My answer is, if it does, you’ve selected the wrong investors, which is a bigger problem. Our emphasis isn’t on slide decks and governance, but instead on helping founders build leadership, steady cadence and periodic strategic discussion into their thinking, which we believes contributes to startups being more prepared for a successful A Round.”

We all need people who can help us grow as a person and make better decisions. No one has perspective on themselves. Some people are obviously more self-aware than others of course, and some people have zero self-awareness. As an example of a healthy balance, Munger says about Buffett: “Warren’s a lot more able than I am, and very disciplined.” Buffett says Munger is “both smarter and wiser.” Well-chosen colleagues can help make you a better investor, business person and human being. The best venture capitalists roll up their sleeves and stand shoulder to shoulder with founders.

10. “At the seed stage there are just some things you can’t outsource and fundraising is one of them. Having a banker or adviser behind the scenes helping you understand the venture process? Maybe (although there’s so much more info out there these days than 10 years ago). But having this person approach me with an ‘I’m representing Company XYZ which is looking for funding’ email? Not the way to start off our relationship.”

The relationship between founders and their venture capitalists is like marriage in that it must last for many years. Personal chemistry is very important. The importance of doing due diligence on the character of venture capitalists and not just their investing acumen will pay big dividends for any founder and the same is true for venture capitalists doing due diligence on the character of founders.  How do they treat people? Not just people they feel are “important” or that can help them, but everyone. How do the treat their friends and family? How do they treat a total stranger? Are they still around for friends and family when the chips are down or something has gone wrong? Are they kind? Do they have empathy? Do they stand up for what is right?  Do they keep promises? Are they compassionate? Do they pitch in?  Do they walk their talk?

11. “Work on projects that matter. If you find yourself treating your job like, well, a job, you should either figure out how to be more passionate about it, or find a new gig.” 

Life is short. The older you get, the more you should realize that every minute of every day is precious. I wrote in #2 above about how passion will make you more successful, but there is also the fact that doing what you are passionate about will make you happier. Happiness is highly under-rated. Working with people who are happy is also under-rated.

12. “The Bottom Up Economy is about the global transition from an industrial economy to a technology-based one. It means there’s not really a single ‘technology industry’—every industry is being shaped by tech. Out of both opportunity and necessity, new marketplaces, revenue streams and efficiencies are being created.”

Every company of significant size is now a technology company. They are also all software companies. Not everyone must be a programmer, but everyone must understand the importance of and uses of software. While there are still management teams that do not understand the importance of software, they will not be able to survive as managers much longer. Software is eating the world. And the world is eating software.

Notes:

View story at Medium.com

https://blog.mixpanel.com/2016/07/06/hunter-walk-early-stage-venture-capital/

https://redef.com/source/529657a5bc4626126841af6d

http://technmarketing.com/tech/an-interview-with-hunter-walk-partner-at-homebrew-and-previous-consumer-product-management-lead-at-youtube/

How VCs Spend Their Time. Err, How This VC Spends His Time.

http://money.cnn.com/interactive/technology/15-questions-with-hunter-walk/

http://www.fluffylinks.com/hunter-walk-interview

You’re Either Venture-Backed or a Lifestyle Business: The Big Lie

Two VCs Interview Me While They Drive: A Transcript

https://www.laserfiche.com/simplicity/3-questions-hunter-walk-creative-economy

Steve Blank: https://steveblank.com/tag/early-stage-startup/page/2/

Fred Wilson: http://avc.com/2009/04/the-venture-capital-math-problem/

A Dozen Lessons I Learned from Bill Gates Sr.

*temp*

Bill Gates Sr. is one of three mentors I have had that were actually appointed by a group to help me develop as a person. I have had other mentors that I recruited or the relationship just developed. What Bill taught me was not only important but inevitably delivered at just the time I needed the guidance most. Other than my parents, who attended college with Bill and his first wife Mary, no one has had more influence on who I am. I probably never go through a day where I do not think subconsciously at least once: “What Would Bill Gates Sr., do in this situation?” Having Bill Gates Sr. be your mentor is the equivalent of being able to start a career and life at third base. Bloody hell was I lucky. Set out below are a dozen of the many things he taught me.

  1. “I am an optimist.” He is always optimistic and forward thinking. The only time I ever saw him less that fully optimistic was at a lunch right after his wife Mary died. That day at the restaurant he said emphatically as tears poured down his cheeks: “I will never marry again,” which goes to show that he is not always right since he married Mimi Gardner Neill about a year later.
  1. “There’s power in sharing stories.” The holiday card Bill sends each year and the corny poems he traditionally recites at events are all about storytelling. Bill also uses stories when talking to clients to who looked to him for wisdom as much as they did legal advice.  This reminds me of the great story about his son who said after being chided about being slow getting into the car for a family event: “I’m thinking, mother. Don’t you ever think?” Bill once recalled that day in this way: “Imagine yourself in our place. I was in the most demanding years of my law practice. I was a dad, a husband, doing all the things parents in families do. My wife, Mary, was raising three kids, volunteering for the United Way, and doing a million other things. And your child asks you if you ever take time to think.” 
  1. “A start-up business is just virtually 100 percent devotion both in time and energy.” Together with a few other people Bill built both a fine law firm and a solid business. Like most businesses the law firm was not a Microsoft class grand slam financial outcome, but it was a fantastic result nevertheless. The vast majority of businesses are more like the law firm Bill created than Microsoft, Facebook or Google. 
  1. “As conflicts arise between parents and children from common causes, the whole business of exerting independence, fighting against discipline, that’s an experience we had, and it was one that was particularly the case with my son and his mother for a period of a couple of years. It obviously worked itself out at a very early date. An interesting piece of that was the consultant that we went to and talked to about this. Mary and I would go in, and our son would go in and talk to this fellow. This went on for a better part of a year and a half. Toward the end, Mary and I were there for a meeting with him, and he said, ‘You have this war going on with your son — you really should understand that he’s gonna win.'”  Pick your battles and especially your wars.

G2

  1. “Woody Allen said, ‘Eighty percent of success is showing up.’ And, I believe that.  If you’re on a board, a committee of some kind, and you go to a meeting and nobody else showed up… You support causes by showing up and, obviously, participating.”  It is stunning how many boards, committees and groups Bill has participated in over his career. His influence is everywhere you look in Seattle and, if you look at the influence of the Bill and Melinda Gates Foundation, the world.  As just one illustrative example, in the early 1980s he involved me in an effort to move technology from the University of Washington to the private sector. The Washington Research Foundation was organized in 1981 and the Washington Technology Center two years later to foster the transfer of technology from university researchers to commercial businesses. He knew then that it is the positive spillovers a great research university that drives the economic and cultural vibrancy of a city. Having the opportunity to watch him operate in that setting was life changing in terms of developing my skills.
  1. “I believe in the combined power of men and women who ‘show up’ for the people they love and the causes they believe in.” The whole of people’s participation in a cause is worth more than the sum of the parts when it comes to “showing up.” Bill believes that everyone who has been fortunate in life needs to do something to counteract what he calls the “disadvantages that random chance has imposed on others.”
  1. “Society works better when people think less about ‘me and mine’ and more about ‘us and ours’.” “We’re all in this together.” Making this point is best done by looking at two examples. The first example concerns the United Way campaign which is always an important activity in the life of Bill Gates. He understands the power of people helping others in a community. His enthusiasm causes other people to become involved and that snowballs. The second example involves an after work basketball team that I played on with Bill. He played center and I was a guard on that team since I am a full foot shorter than he is  (which is why I always wanted to be like him when I “grew” up). He was an unselfish player more concerned with making a great pass than scoring himself. On this team and in other settings he was always thinking about “us and ours” and not “me and mine.”
  1. “I’ve seen the power of public will to take on and surmount great challenges.” “I don’t care if you carry a banner or if you stand near the back. You can yell into a microphone if you like or you can listen carefully if that’s your style. You don’t need a soapbox to be a good citizen, you just need to be part of the public will to make life on this planet a little better.” How can you say it better than that? When Bill turned 90 years young in 2015 his birthday party held at the University of Washington was attended by many luminaries. Over the course of his career he helped many people and numerous stories were told at that event about his positive impact on their lives. A book of memories was produced for that event in his honor.  In one memorable chapter in that book Howard Schultz wrote that without Bill’s help in dealing with an unscrupulous character he would not have been able to buy Starbucks. If Seattle has a George Bailey equivalent (a lead character in the movie “It’s a Wonderful Life”) it would be Bill Gates Sr.
  1. “I’ve experienced the fear of being poor, the exhilaration of working hard to build a career.” “Dad was very hard-working – he had a partnership in a furniture store, worked very hard, worked long hours. And I learned from seeing that.” “My parents never talked about showing up. They just did it.” There wasn’t a lot of structure to my growing up. I had an awful lot of discretion about where I went, what I did, who I did it with.” The way children are organized today by parents is quite different than what Bill experienced. One thing this upbringing did was force him to learn from mistakes since he had lots of chances to make them. I can’t help think that this experience is a significant part of why Bill has such sound judgment. Bill was on the board of directors of Costco with Charlie Munger who is an advocate of learning from mistakes. Charlie said once: “We look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” Bill contributed to my personal development in many ways not the least of which was the idea of sound judgment. “Ready, aim fire” not “Ready, fire, aim.”
  1. “Hard work, getting along, honoring a confidence and speaking out.” These are the attributes I saw in him as a business leader and community volunteer. He polished each attribute that he learned as a boy scout under scoutmaster Dorm Brahman. He did not forget those lessons. I remember once seeing him tie a fancy knot on a speedboat at his home on Hood Canal (you can take a boy out of scouting, but not take scouting out of the boy).
  1. “You should never demean your child. When you think about the centrality of that, in terms of the relationship with an offspring, you’re off to a really good start.” The centrality of his family in everything Bill does is an inspiration.  The way the family operates as a team is also marvelous to watch.
  1. “For all the rewards of private life, my life would have been much the poorer if I had not experienced those moments when I felt like I belonged to something larger.” There is arguably no organization where he has had more impact that the University of Washington. And the reverse is also true. There is a biographical article about Bill entitled: “Mighty are those that wear the purple and the gold.” He is mighty indeed. Go Huskies!

Biography: Bill Gates Sr. earned his bachelor’s and law degrees from the University of Washington, following three years of military service. A founding partner at Shilder, McBroom, Gates and Baldwin, Gates has served as president of both the Seattle/King County Bar Association and the Washington State Bar Association. He has served as trustee, officer, and volunteer for more than two dozen Northwest organizations, including the Greater Seattle Chamber of Commerce and King County United Way. In 1995, he founded the Technology Alliance, a cooperative regional effort to expand technology-based employment in Washington. Gates also has been a strong advocate for education for many years, chairing the Seattle Public School Levy Campaign in 1971 and serving as a member of the University of Washington’s Board of Regents from 1997-2012.

Notes:

Mighty are those that Wear the Purple and the Gold http://www.washington.edu/alumni/columns-magazine/june-2013/features/gates/

Showing Up for Life  https://www.amazon.com/Showing-Up-Life-Thoughts-Lifetime/dp/0385527020/ref=sr_1_1?ie=UTF8&qid=1495307985&sr=8-1&keywords=Bill+gates+sr

Whitman Commencement Speech http://www.networkworld.com/article/2279854/data-center/lessons-from-bill-gates–dad–whitman-college-commencement-speech.html

Showing Up http://www.law.washington.edu/Multimedia/2009/ShowingUp/Transcript.aspx

How would Ann Miura-Ko have reacted if Bill Gates had walked into her office in 1975?

Ann Miura-Ko is a Partner at the venture capital firm Floodgate. She is a lecturer in entrepreneurship at Stanford. Prior to co-founding Floodgate, she worked at Charles River Ventures and McKinsey and Company. Some of Miura-Ko’s investments include Lyft, Ayasdi, Xamarin, Refinery29, Chloe and Isabel, Maker Media, Wanelo, TaskRabbit, and Modcloth. She has a BS from Yale University (EE); and a PhD from Stanford University (Math Modeling of Computer Security.)

Since my post from last weekend was about Floodgate’s co-founder Mike Maples Jr., I decided to write about Miura-Ko’s ideas in the context of a specific early stage business I know something about (Microsoft in the 1970s and early 1980s). Miura-Ko’s ideas are, as usual, in bold text and my commentary follows. This post is different in that I am commenting on a specific hypothetical and how Miura Ko’s ideas and approaches might have been applied. This is an experiment and I may or may not do this again.

The thought experiment is as follows: Imagine you are Miura-Ko, had been sent back in a time machine and a 20-year old entrepreneur named Bill Gates walks into your office in 1975. Instead instead of bootstrapping Microsoft’s business like he did in real life, he is in this hypothetical seeking seed stage venture capital.

  1. “The priority as an early stage startup is at the bottom of the stack  —  What is the unique advantage or insight you are building your product on top of? The product/market fit will come later after your key insight of what your unique advantage is.”

The stack Miura-Ko is talking about in the bold text is a key part of the Floodgate investing process which starts at the bottom of this stack below and works up.

value stack

Miura-Ko is saying that at Floodgate the process starts with a careful look at strategy (i.e., whether business might be able to achieve a sustainable competitive advantage). Miura-Ko’s interest in “the unique advantage” of the entrepreneur is directly tied to the “proprietary power” of the business, which in essence is about creating sustainable competitive advantage. If everything that a business offers can be easily replicated by other businesses, then the entrepreneur’s business won’t be very profitable.

Let’s apply Miura-Ko’s process to the hypothetical. What were Bill Gates and Paul Allen thinking about when they formed Microsoft?

They had reached two important conclusions:

  1.  Computers would be owned by individuals; and
  2.  Software rather than hardware was the key to sustainable profit.

To make the investment Miura-Ko would have believed that software rather than hardware was going to be Microsoft’s “unique advantage.”

This focus on software seems obvious now but it was not obvious in the 1970s. I am not saying making hardware is never a good idea, useful to sell software or otherwise valuable but the fateful decision to focus on just software early in the life of the Microsoft business meant that the business was “capital light.” Microsoft never really needed to raise venture capital as a result and did so only once to convince Dave Marquardt of August Capital to join the board of directors. When Microsoft eventually went public years later Bill Gates alone owned nearly 50% of the outstanding shares because the business did not require a lot of externally provided capital to grow.  Microsoft went public when it did only because it had too many shareholders and SEC rules required that it do so.

Strategy is about deliberately deciding to be different and finding unique advantage. Here is Bill Gates describing his thought process in creating a strategy for Microsoft in 1975:

“The original insight for Microsoft was this: What if computing was free? The answer: Individuals would use computers as a tool, and software standards would become the critical element in making this happen.” Fortune, January 16, 1995

Paul and I

“When you have the microprocessor doubling in power every two years, in a sense you can think of computer power as almost free.  So you ask, Why be in the business of making something that’s almost free?  What is the scarce resource? What is it that limits being able to get value out of that infinite computing power?  Software.” Playboy, July 1994

This is from ~ 40 years later (June 2017):

40 years

The analysis by Gates that resulted in a focus on software was microeconomics linked to an observation about technology. That is was done by someone his age at that time is history was amazing.

  1. “If you are asking if you have product/market fit, you do not.”

A business that spends most of its time desperately trying to keep up with customer demand and has a scalable business model has found product/market fit. This is the part of the stack that Floodgate refers to as Layer 2 (Product Power).

The history of Microsoft again is an interesting example of product/market fit. It was in 1975 that the MITS Altair 8800 appeared on the cover of Popular Electronics and inspired Gates and Allen to develop a BASIC language for that device. In 1975 Microsoft revenues were only $16,005. Would that have been enough to get Miura-Ko to invest in Microsoft at seed stage? I think so. The bet she made on Lyft supports my conclusion. Here below is Miura-Ko on Lyft:

“I invested in Lyft when it was still a business called Zimride. I invested because they came in and told me a story about how transportation innovation was critical to significant inflection points in the economy and that they believed such an inflection point was on the horizon. (No other transportation startups existed back in 2010 when I invested aside from Zipcar.) They had a hard time raising their Series A as well. It wasn’t until they pivoted into Lyft in 2012 that they started getting proactive interest from investors.” “Zimride was originally a platform for carpooling and they sold this platform to individual Universities and companies. They were making sales but it wasn’t working as a scalable business model. They had customers but it never felt like product market fit. Lyft was just another experiment that the team tried. They were also looking at doing bus routes from SF to Tahoe, renting vans from SF to LA, etc. The thesis for Lyft was — mobile is big and doing ride sharing peer-to-peer (P2P) would be interesting. The big questions for Lyft before they launched was how big of an idea was this and how confident were they in trying this. Normally the founders had been very nice but when they pitched the idea of Lyft they were very intense about it and the board said to go for it and try it. During the first week of Lyft launching (Zimride was still going on) Tommy Leep who worked with us at Floodgate said — “You have no idea how big this is going to be.” He experienced this magical moment while using Lyft and became one of their early power users. ”

The decision about whether to invest in Microsoft would have been easier for Miura-Ko to make in 1978 when Microsoft’s year-end sales exceed $1.3 million. But a seed stage investor in 1995 wouldn’t have known that.

  1. “It’s the business model that matters. If you send me a 50 page business plan, I probably won’t read it. But send me a picture of your business model all the hypothesis that you have around your business model and I’ll take a really good look.”Alexander Osterwalder has a book on business model generation and so there are different frameworks now that exists out there where you can use them to figure out what your business model looks like.”

The third layer in the Value Stack is mostly about development of a solid business model, which is the way that a business turns innovation into value. Did Microsoft have a sound business model? In 1975 this business model question was tricky, because at the time piracy was rampant which caused Gates to write his famous “Letter to Computer Hobbyists” about software piracy. Gates solved this business model problem by licensing the software to hardware manufacturers who could mostly be counted upon not to violate intellectual property laws.  Gates describes his business model as follows (remember in this thought experiment he is 20 years old and this is 1975):

MITS 2

“It’s all about scale economics and market share.  When you’re shipping a million units of Windows software a month, you  can afford to spend $300 million a year improving it and still sell it at a low price.” Fortune, June 14, 1993

“We keep our prices low and innovate as fast as we possibly can because we are keenly aware of the large number of companies that are single-mindedly working to displace us in every software category.” Upside, April, 1995

  1. “We have our startups do is they’ll go through each component of a business model. In my mind those would be your users, your customers, your pricing which also includes your customer lifetime, how you do customer demand creation, your sales channel, and then on the backend if your producing something or if you have inventory your whole supply chain that could all your components, design, manufacturing, and inventory warehousing.” “How do the customers view you, what’s your value proposition to them? What’s your value proposition to the manufacturers? What’s your value proposition to the sales channel? How do you do demand creation? What’s the cost of customer acquisition? These are all questions that you should be constantly thinking about. And if the dollars in are not greater than the dollars out, then you need to rethink your business model right then and there.”

Gates might have said to Miura-Ko in her office that day what he would say later in an interview: “Our basic business strategy [is] to charge a price so low that microcomputer makers couldn’t do the software internally for that cheap. One of the bigger early contracts was Texas Instruments, where we bid $99,000 to provide programming languages for a home computer they were planning.” I believe Miura-Ko would have seen the potential of early Microsoft given her track record and investing style.

  1. “In the early stage, a good think to look at is — how good are they at early hiring? And what are they willing to give up to get the best people? One of the companies we invested in has successfully hired great talent at some of the top companies around Silicon Valley, even during this highly competitive market. The way they do this is the founders have spent a lot of time thinking about who they want to hire, how they do interviews, compensation structure, etc. They think about these issues just as much as they think about the product.” “If a company is advertising and posting job postings everywhere — this is a sign the company isn’t doing so well. There isn’t anyone who will advocate for your company like the people who are working there already.”

If you have been reading posts on this blog you have seen me write about the fact that missionaries more successful than mercenaries. There is even one post dedicated to just that issue. This matrix below illustrates why being a missionary can be 100% consistent with seeking high profitability.  The issues are separate.

Seeks high profitability No profit objective
Passionate re the product Missionary (Bill Gates at MSFT) Missionary (Bill Gates at the BMG Foundation)
Not passionate re the product Mercenary Volunteer (paying penance for some reason)

Founders who are not passionate about their mission fail way more often. Lots more. Employees and founders who follow their passion do better in their career. The passion and energy of gates and Allen caused many people to join Microsoft. Gates has several times lauded Steve Ballmer for his ability to hire great employees which allowed the company to scale. The team they built was essential to the company that was created. The more great people they hired, the more people wanted to work there.

  1. “We will only invest if there are thunder lizard ambitions but that has nothing to do with how much they raised upfront.”

There is no question though that the ambitions of Bill Gates were huge. This story from the book Hard Drive about Gates takes place right before he would have visited the office of Miura-Ko in my hypothetical.

“Gates had tried to prepare his parents for the fact that he might eventually drop out of Harvard to form a computer business with Allen. As Mary Gates saw it, her 19-year-old son was about to commit what amounted to academic suicide. …Mary Gates turned to a new friend, Samuel Stroum, an influential and respected business leader she had met during a United Way campaign, for help with her son. She arranged for Bill to talk with Stroum, in the hope that Stroum would convince her son to drop the idea of starting a company, at least for the time being, and continue his education at Harvard. A self-made multimillionaire, philanthropist, and civic leader, Samuel Stroum’s advice was often sought, even by the region’s most powerful movers and shakers… “I was clearly on a mission,” recalled Stroum of the couple hours he spent picking Gates’ brain. “He explained to me what he was doing, what he hoped to do. I had been involved in that industry since I was a young boy. He just talked about the things he was doing… Hell, anybody who was near electronics had to know it was exciting and a new era was emerging.” Gates talked about the vision he and Paul Allen shared. The personal computer revolution was just beginning, he told Stroum. Eventually, everyone would own a computer. Imagine the moneymaking possibilities…. a zillion machines all running on his software. Not only did Stroum not try to talk Gates out of his plans to start a business, but after listening to the enthusiastic teenager he encouraged Gates to do so. “Mary and I have kidded about it for years,” said Stroum, now 70. “I told her I made one terrible mistake—I didn’t give him a blank check to fill out the numbers. I’ve been known as an astute venture capitalist, but I sure didn’t read that one right.”

  1. “While you are an early stage startup it’s ok to incur technical debt. During this time period you really aren’t sure what is going to work and what isn’t going to work — the key should be emphasizing on moving fast and making quick decisions vs. making everything perfect.”

Miura-Ko is expressing a thought similar to Mark Zuckerberg’s idea that a business should “move fast and break things.” But in doing this Miura-Ko knows that some technical debt may be incurred and believes that this is acceptable. Ben Horowitz explained technical debt in his recent book The Hard Thing About Hard Things in this way:  

Thanks to Ward Cunningham, the metaphor ‘technical debt” is now a well-understood concept. While you may be able to borrow time by writing quick and dirty code, you will eventually have to pay it back — with interest. Often this trade-off makes sense, but you will run into serious trouble if you fail to keep the trade-off in the front of your mind.”

Almost every software company that is ambitious gets into a situation where there is some technical debt. When I asked a close friend for a good example of technical debt involving Microsoft he said:

“With MS-DOS Word huge effort was undertaken to port the code to serve the Mac (and then the Windows code base). The debt though was that the data structures were designed for very small amounts of real mode memory and floppy disk space which were not the right assumptions to make for Windows with paged memory and hard disks.”

1

  1.  “A lot of people get confused because we as a firm also talk a lot about Customer Development, the Lean Startup methodology. And they say, ‘Well how is that consistent with Lean Startups?’ The problem is people confuse lean with small. Lean has nothing to do with small. In fact the amount of capital that you’ve taken has nothing to do with whether or not your ambitions are big or small.  … Lean is not small. Lean is a tactic by which we help our entrepreneurs and the entrepreneurs help themselves in a data driven way figure out how they’re going to iterate their product.”

Bill Gates had to watch cash carefully since in the very early days there was a lot of uncertainty about revenue. When he meet with Miura-Ko in my hypothetical Microsoft would have had $16,005 in revenue and three employees. Gated would eventually go through a cash crisis when MITs stopped being a source of revenue. In an interview many years later the two Microsoft founders described the problem:

Gates: “It could get scary. In our very first contract with MITS, we set them up to sell our BASIC to their customers, rather than us selling to computer buyers directly. We thought it was a good deal because they agreed to make “best efforts” to sell it. But later they decided not to sell to anybody at all because there were so many illegal, free copies of our BASIC floating around, so why try to charge people for it? That really made us mad because we thought it encouraged piracy. We eventually went into arbitration to determine if they were in compliance with the contract. In the meantime we were totally out of money…

Allen: …because MITS was withholding payments from us while the arbitration was going on.

Gates: They were trying to starve us to death. We couldn’t even pay our lawyer. They tried to get us to settle, and we almost did, it was that bad. The arbitrator took nine months to issue his damn opinion. But when it was all over, the arbitrator ripped them apart for what they had done.

Allen: That case really, really scared us. If we had lost, we would have had to start over. Bill would call up his dad for advice. We were on pins and needles the whole time.

Gates: But, you know, through it all, we never borrowed money. I always felt like if we had to, we could have. But we never did.”

Gates would later write in his book The Road Ahead about the impact of that experience:

“After that episode, Microsoft has been perpetually cash flow positive. In fact, I developed a rule: We always have enough cash on hand to be able to run the company for at least a year if no one pays us. The MITS experience, suddenly having no income, made me very conservative, a trait that persists to this day.”

  1. “Nowadays people talk about pivoting as changing the homepage on your website and calling that a pivot. That’s not a pivot. A pivot is when you feel sick and you are going to throw up because what you are working on is such a dramatic shift and you don’t know if it will work or not.” “[As an example] the founders had this dilemma where Lyft was taking off but they still had Zimride going on at the same time. We went for a walk and they asked — what should we do with this other asset we have — should we move people over to Lyft? At the time this was a really difficult decision to make but we decided to move everyone onto Lyft. In hindsight this is a no-brainer decision but you need to understand the founders spent 3 years of their life selling the idea for Zimride, building Zimride, raising money for Zimride, having users for Zimride, and sacrificing weekends / friends / family to try to make this happen. Then you are faced with the realization that what you have been building this whole time isn’t working, but this thing you spent a month on is working. It takes a lot of courage to shut the thing down you have spent all of this time and energy on. I appreciate the courage it took for the founders to move aggressively into Lyft.”

Microsoft never did a pivot. So this is a hard one to put in this thought experiment.  While it was not a pivot, for Bill Gates and Paul Allen a prior business impacted what they would do later at Microsoft:

“While Traf-O-Data was technically a business failure, the understanding of microprocessors we absorbed was crucial to our future success. And the emulator I wrote to program it gave us a huge head start over anyone else writing code at the time. If it hadn’t been for our Traf-O-Data venture, and if it hadn’t been for all that time spent on UW computers, you could argue that Microsoft might not have happened.”

However this example did not involve the gut wrenching shift that Miura-Ko describes.

  1. “As an early-stage investor I’m not in the crazy fray of investing in companies once everyone recognizes the company is on a hockey stick trajectory. It’s my job to recognize the early signs of something interesting.”

I have already said that I believe Miura-Ko would have seen the potential of Microsoft in 1975 and would have made an investment if asked. But that was another time and place. Making early stage bets means a lot of investments will fail. It is easy to look back at a great success and say: “I would have invested in that.” To illustrate, someone who did not see the potential was an engineering student at the University of Washington who worked with Gates and Allen on their Traf-O-Data business had many conversations with Gates and Allen about PCs. He recalls: “The whole concept of having a big clunky PC in your house that just used up room, I thought that was totally dumb. I did not have any foresight into what was really going on. I just kinda fought it in my mind, and said, ‘Nah, this is not going to work.’”

  1. “We have invested in solo founders but the healthier dynamic is to have 2–3 co-founders. Being a solo founder is lonely and you are a prisoner to your own startup — that kind of dynamic can be really bad. Having 2–3 team members you feel much more social pressure to stay in the game and can focus the whole team on a problem, in general, teamwork is a more healthy dynamic. The other problem is there is no superhuman founder, everyone has their own weaknesses. It’s better to round out the edges of your weak spots.”

The early team at Microsoft was amazing. They all just fit together and created this positive feedback loop (lollapalooza) of success. The right people kept arriving at the company at just the right time year after year. When Miura Ko met Gates in this thought experiment there might have been just three Microsoft employees.

In addition to Gates and Allen these people worked at Microsoft in the very early days:

Steve Wood was a programmer who developed a version of FORTRAN for the 8080.

Bob Wallace was a programmer who developed a version of BASIC for Texas Instruments (TI).

Jim Lane was a programmer who was hired to write a DEC simulator for Intel’s new 16-bit chip, the 8086.

Bob O’Rear was a programmer who worked on a translator to turn the 8080 BASIC code into 8086 code.

Bob Greenberg was a programmer who worked on developing TI BASIC.

Marc McDonald was a programmer who worked on converting 8080 BASIC for the NCR machine.

Gordon Letwin was a programmer who developed a BASIC compiler.

Andrea Lewis was a technical writer. Marla Wood was a receptionist/secretary/bookkeeper

Many thousands of key people like Ballmer, Shirley, Gaudette and Maples Sr, would later join Microsoft just to name four. The problem I have about going further with names is that the list is long and if I leave someone out I will make that someone very unhappy. So I will stop at four. The important point is that these people balanced each other well and the whole was more than the sum of the parts.

  1. “Gutenberg was probably one of the first people who ever got venture capital so he had a business partner by the name of Faust and he went out and had this idea around the printing press and he got the equivalent of 5 years’ worth of peasants pay to get started on his business. His series B financing came about when he realized he needed a little bit more financing, so this time he asked for little bit more capital from the same guy and the guy gave him the equivalent of 10 peasants stone built houses. So he went along, made a few more mile stones and then had to go back for a series C financing. And then sure enough he was able to get that and it was the same amount; the amount that would basically pay for 10 stone houses for a peasant. And it turns out that the story ends very sadly. He wasn’t really able to satisfy his investors. His investors as you may have heard from other stories from entrepreneurs an investor gets very anxious, wants to see more milestones, he isn’t sure why this isn’t proceeding and eventually sues and he wins and he’s able to buyout Gutenberg’s portion of the printing store. Gutenberg actually died a relatively penniless man and most people don’t really realize his contributions to the printing press until much, much later. And the history books are then changed to reflect his contributions. Now my story today about investors and entrepreneurs is totally different. I believe actually that this whole relationship between innovators and investors is actually very much switched. The power has shifted to the entrepreneur.”

This is excellent story-telling by Miura-Ko which makes an important point: great founders are what creates Thunder Lizard businesses. Gutenberg was a great founder who did not have a great financial result.  But he did change the world in a very significant way. Capitalism requires failure since that is what drives a better life for society as a whole. The cities that produce that most successful startups and the most innovation do not treat failure as a stigma. Firms like Floodgate and investor like Miura Ko help make that happen. But it is the founders that matter most.

Notes:

Miura-Ko: http://ecorner.stanford.edu/videos/2540/Funding-Thunder-Lizard-Entrepreneurs-Entire-Talk

Miura-Ko: https://medium.com/cs183c-blitzscaling-class-collection/class-4-notes-essay-reid-hoffman-john-lilly-chris-yeh-and-allen-blue-s-cs183c-technology-428defb04850

Miura-Ko: https://medium.com/cs183c-blitzscaling-class-collection/cs183c-session-4-ann-miura-ko-98617f03b580

Miura-Ko: https://techcrunch.com/2016/07/06/floodgates-ann-miura-ko-on-the-four-powers-all-venture-backed-startups-share/

Miura-Ko: https://www.geekwire.com/2017/true-seattle-tech-engineers-loyal-san-francisco-indeed-data-confirms/

Allen and Gates:   https://www.geekwire.com/2017/bill-gates-paul-allen-business-microsoft-engineer-partner/

Fortune interview: http://archive.fortune.com/magazines/fortune/fortune_archive/1995/10/02/206528/index.htm

Gates Smithsonian Oral History: http://americanhistory.si.edu/comphist/gates.htm

Ben Horowitz (The Hard Things About Hard Things): https://www.amazon.com/Hard-Thing-About-Things-Building/dp/0062273205

The Road Ahead: https://www.amazon.com/Road-Ahead-Bill-Gates/dp/0453009212/ref=sr_1_2?s=books&ie=UTF8&qid=1497272499&sr=1-2&keywords=the+road+ahead

A Dozen Lessons about Business and Investing I’ve Learned from Mike Maples Jr.

 

Mike Maples, Jr. is a Partner at Floodgate. Before becoming a full-time investor, Mike was involved as a founder and operating executive at back-to-back startup IPOs, including Tivoli Systems (IPO TIVS, acquired by IBM) and Motive (IPO MOTV, acquired by Alcatel-Lucent.) Some of Maples’ investments include Twitter, Twitch.tv, ngmoco, Weebly, Chegg, Bazaarvoice, Spiceworks, Okta, and Demandforce. This is the first time I have written about the son of someone else I previously profiled on this blog. Maples has an M.B.A. from Harvard Business School and a Bachelor’s degree in Industrial Engineering and BS degree from Stanford University. Next weekend I will profile the co-founder of Floodgate, Ann Miura-Ko. Floodgate is an early stage venture capital firm that wants to invest and assist “the iconic companies with the biggest impact. Floodgate backs these Prime Movers before the rest of the world believes.”

 

  1. “Floodgate uses a framework called the “value stack” [which is] a hierarchy of powers. Each is powerful on its own, but as these advantages are layered on top of each other they reinforce and amplify each other even further.” “We are proud to have been one of the tiny number of firms to have invented the micro-VC space over a decade ago. Back when we got started in 2005, it was very hard for a founder to raise $1M. They had to raise a whole lot less or be de-risked enough to raise $5M from a traditional VC.”

If you have read the work of Michael Mauboussin you have seen him make this point repeatedly: “elite performers in all probabilistic fields all think in terms of process versus outcome. So while our society may be conditioned to focus on outcomes, an emphasis on process makes the most sense for the long haul.” Maples has thought deeply about Floodgate’s investing process and can articulate a clear investing thesis. Floodgate believes that the right “stack” (the co-founders were trained as engineers after all) assembled in the right order will potentially generate value which is far more than the sum of the inputs. The first layer in the Value Stack is Proprietary Power which is when the conditions are right tightly coupled with Product Power (the second layer). The business model layer is next the stack and so on. When all the layers are skillfully put into place in the right order, Floodgate’s thesis is that the value created by the process increases non-linearly. This is an example of what Charlie Munger calls “a lollapalooza.”

Maples is naturally focused on the lower layers in the Value Stack since he is an early stage investor, but even then, the potential for the higher layers must be there and some groundwork done on the higher layers.

Maples depicts the Floodgate stack as follows:

value stack

PROPRIETARY POWER: “is about having a structural competitive advantage is critical for avoiding mindless competition.”

  1. “Whenever I look at a company that says they have a technology advantage, I’m interested in a couple things. One is, just what is the advantage, and why would it be hard to copy? But then the other part of the question is, why now? Why did something in the world change to open the world for this opportunity? [For example] if you’re doing topological data analysis, why couldn’t that have been done five years ago? Why couldn’t that have been done 10 years ago? Well it turned out that computational capacity in the cloud was improving, improving, improving at the rate of Moore’s Law, and eventually converged at a critical point where it became practical.” “The problem with mimetic desire is that it’s the wrong ‘personal operating system’ for coming up with a breakthrough idea — it is by definition an incrementalist view of the world that emphasizes following the rules and outcompeting others, rather than re-inventing the rules and transcending competition.”

Strategy is important at every stage of the life cycle of any business. If investors can’t see a source of sustainable competitive advantage it will be hard to raise a financing round. A startup can easily die an early death without some credible of path to achieving a sustainable competitive advantage. Someone may say: “Wait what does this competitive advantage concept really mean?” What it means is that unless there is some constraint on supply it will increase until profit is equal to the opportunity cost of capital. Here’s an example: Imagine you have a stand selling bananas on a city street. And 26 other people start going the same thing sourcing the bananas from your wholesale supplier. That is an extreme example of zero proprietary power. Maples adds: “The best way to compete is to choose not to.” Strategy is what you do differently than your competitors. It is about choosing what not to do.

If you want to understand more about strategy people like Bill Gurley suggest reading Porter’s book Competitive Strategy.

mp

In his search for proprietary power Maples is looking for a breakthrough idea that re-invents rules and transcends competition. What is it that the business will do that is unique? What rule can it break that others thought it was sacrosanct? This is where thinking different can pay in a huge way once in a while. Thinking and acting different will not always succeed, but when it does: boom!

Maples has said on other occasions that lower costs at seed stage are both good news and bad news. Here is his slide:

up down

Let’s be clear that this is a discussion about startups that are suitable for an investment by a leading venture capitalist like Maples. This post is not about opening a new bicycle repair shop. As will be explained below, a business must have a number of essential qualities to be suitable for a venture investment. To put the challenge in context, only 800 new firms raised a Series A round in venture capital in the US in 2016. While this represents a tiny percentage of overall business starts in that year or any year, a few of these business will have an out-sized impact on society. Can the number of series A investments in a given year go up? Organizations like Y Combinator, 500 Startups and Angel List are pushing hard to change this. I hope they are successful, but we do not know the outcome yet.

  1. “The most valuable businesses in the world are going to be networks. I believe the big companies of the world today, if they don’t position themselves to be network-centric, they will fail. I believe that Tesla is a network centric car company. I believe Apple is a network centric phone company. I believe that the twin powers of Moore’s Law and Metcalfe’s Law are what is going to bring abundance to the world in the next 10 or 15 years.”  “If you’re going to build a network effects business, it’s important to ask yourself, what is my network? What are the nodes of the network? How do they connect with each other? Where are the connections strong? Where are they not strong? Is it a global network? Is it a hub and spoke network? What does it mean for me to be the network operator? Interestingly, network effect businesses have existed for a long time. They existed with the railroads, they existed with canals, they existed with RCA, with records, and TV. They existed with Craig McCaw and McCaw Cellular.”

The factor that creates the most competitive advantage in the business world today is network effects. The increased importance of network effects is explained by what Marc Andreessen calls “software eating the world” (the increased important of software in business value chains). Another multiplier of the importance of network effects is that so many systems and networks are now interconnected. Other factors that can potentially create product power like patents, economies of scale and regulatory advantages are still important, especially when combined with network effects, but they are relatively less important than they were in the past.  I do appreciate the shout out by Maples to McCaw Cellular and Craig McCaw since that is part of my heritage. People in many cases have forgotten how capital intensive the early cellular business was particularity for new entrants and how much money had to be raised in places like the high yield markets to make the business model work. They were not the “capital light” platform businesses that Warren Buffet marveled about at the last Berkshire shareholder meeting.

PRODUCT POWER: “is about achieving product/market fit.”

  1. “Have you ever seen a startup where you’re like, how in the hell could they have been successful? It’s because they met a great market. And sometimes, your product, your market, it just has the magic. You can’t beat customers off with a stick. They just want it. I’ve had this happen to me before, where in spite of the fact that the product just seemed horrible on the surface, it just didn’t matter. People wanted it really bad. Product market fit is more of like a dance between the product and the market. You know it’s like if you ever see two people doing the tango, I look at it like the product is leading the dance, but the market is tangoing with the product. I’ll try to be G-rated in my language, but sort of an intimate sort of back and forth between them. And what I find is that if you want to get the tango right, the first thing is to really identify the market. Large, strong customer desire and the right time. You want to find markets where people gravitate to your idea and want it right now, as soon as possible, even if it’s half done. And then that market pulls the product. When a market pulls a product, this is what it feels like inside the building. Nobody’s debating what the features of the next version ought to be, because they’re like, oh my god. This stuff is flying off the shelves, and our customer needs us to fix x, y, and z. And you’re like, OK well let’s fix it. And so that’s what it feels like when the market’s pulling the product. Whereas where the market’s not pulling the product, the conversations in the building are arguments over, why aren’t those customers smart enough to figure out how awesome our stuff is?”

When a business has discovered genuine product/market fit the business will know it.  The primary focus of the business will be on satisfying demand. If the team is spending all their time adding features, the business has not yet found product/market fit. The best businesses generate organic growth and do not need Herculean spending on marketing and sales.

  1. “Most investors are overly focused on traction right now. The problem with that is it can be gamed in the short term. And even worse, it often instills a mindset of iterating metrics to nowhere. It’s more important to us that the startup has a structural competitive advantage and is on the path to creating a product that blows people away in large potential numbers. I have never seen an awesome product with a fundamental advantage and lots of potentially delighted customers not be able to make money.”

Maples is pointing out that without a proven value hypothesis a decision by a business to proceed with proving they have a solid growth hypothesis is counterproductive since resources are being wasted. Traction with a product that lacks core product value won’t last.  That some investors and business put too much focus on traction at seed stage does not mean that traction does not matter.

Yes, eventfully the growth hypothesis must be proven. Maples once included these benchmarks in a slide deck:

trac

BUSINESS MODEL POWER:  “involves translating a startup’s innovation into attractive profits that can improve rapidly.’

  1. “A business model is the way that a business converts innovation into economic value.” “You just have to discover it, but is there always. And then increasing margins and pricing power are proof that the first two layers are strong. It’s axiomatic that if your pricing power is going down, the first two layers aren’t that strong. Either that, or you’re dumb at pricing. But it’s more likely that you’ve overestimated how compelling your product is or how strong your competitive advantage is. The Business Model Canvas by Alex Osterwalder is good to look at for this. But a lot of what I find about business modeling is it is just intuition. When you get to know the customer really well and what they value, it just seems to work.’

Business models fascinate me since they are all unique and are always changing in an environment that is always changing. They all also must cope with nests of complex adaptive systems. The number of potential business model permutations are endless. How can any game on Earth be more interesting than that?

Maples and a group of people like his partner Ann Miura-Ko as well as Steve Black and Eris Reis clearly talk a lot and share many of the same ideas. The output of this process is interesting since it reflects an engineering approach to creating new businesses. Actually going through the Business Model Canvas by Alex Osterwalder (see below) with real examples is quite an instructional process.

ost

COMPANY POWER “is about avoiding management and technical debt.”

  1. “The common element of Twitter, Lyft, Twitch.tv, Okta, Demandforce, Weebly, Chegg, Xamarin, Refinery29, Spiceworks, Playdom, and ngmoco] as startups is that their teams were amazing. They were amazing in their domain knowledge for the products they were building and they were amazing at their ability to ‘McGyver’ great outcomes in harrowing and uncertain circumstances. It’s surprisingly rare for a startup team to be able to execute at the level of speed, urgency, and precision required to build a real company.”

Three essential elements in a startup are team, market and product. Or market, team and product. This is essentially another mental model or stack that is useful in understanding a business. The degree of emphasis varies on the first two elements depending on the venture capitalist.  Certain people and teams in certain situations are capable of amazing feats of creativity. More money is not necessary and in some cases is a hindrance.

Before proceeding to the next quote, a side bar on technical and management debt is perhaps useful. Let’s start with a Wikipedia definition:

“Technical debt (also known as design debt or code debt) is ‘a concept in programming that reflects the extra development work that arises when code that is easy to implement in the short run is used instead of applying the best overall solution’. If technical debt is not repaid, it can accumulate ‘interest’, making it harder to implement changes later on.”

Management debt is incurred when a founder or manager makes expedient, short-term management decisions which have costly long-term consequences. If management debt is not repaid, it can accumulate ‘interest’, making it harder to implement changes later on.

  1. “A lot of the good companies that I’ve seen actually proactively define their culture. And they emphasize what that is their first 20 employees, and then it kind of takes a life of its own. Why do you want that? It’s sort of like when ducks fly south for the winter, you don’t have to tell the ducks in the back of the v, get in the v. They just know. And when a company gets into blitz scaling mode, you don’t have time to tell the hundreds of new employees that you hire, here’s how decisions get made here, here’s what we value, here’s how we make tradeoffs at the margin. They have to be programmed in the DNA of how they participate in the company. Basic management systems. This has to do with just one-on-one meetings, board meetings, team meetings, forecasting frameworks. You know, what gets covered in those meetings, what shouldn’t get covered in those meetings. Just having a sort of a philosophy of that going in can save a lot of time and avoid a lot of management debt.”

The right company culture not only allows a business to scale, but minimize and resolve problems as they arise.  It allows decision-making to be distributed, optimized and expedited. Warren Buffett has written: In businesses, culture counts….Cultures self-propagate. Winston Churchill once said, ‘You shape your houses and then they shape you.’ That wisdom applies to businesses as well.” A partner from the venture capital firm Greylock had a blog posted recently in which they said: “Culture Is How You Act When No One Is Looking.” The title alone makes a strong point. When you are working with people you know and trust, tremendous efficiencies are created. Charlie Munger has said on the importance of culture:

“The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.”

  1. CATEGORY POWER: “is [about] designing and owning a category [so as to make] the business the “Category King” [which] usually capture 70–80% of the profit pool in their markets.”

This is the least important layer for a seed stage business, but as I noted above the potential for this layer is attractive to an early stage investor. In this layer along with the Company Power layer ground work is still being done at seed stage says Maples. Ann Miura Ko describes the Category Power layer this way:

“One thing we have noticed is the best companies will spend the time to create a whole new category in the market for themselves, because they don’t want to compete on other people’s terms. They want to be the only Thunder Lizard on the block. For example, Netflix didn’t start out trying to be a better Blockbuster. They created their own separate category and then completely destroyed Blockbuster. Another example is Starbucks — who would have ever thought people would buy $5 coffees when other coffees at that time was selling for 50 cents. They created their own new category. Category power is the ability for the founders to think about the language of the market they are going into, and how they define this for their company. If they are allowing the existing market to define who they are — we get worried about this.” 

VENTURE CAPITAL AND STARTUP OUTCOMES:  

  1. “I’m interested in not just companies that are doing a startup, but companies that are doing something hyper-exceptional. And I was seeking a metaphor to describe these companies. And I wanted it to combine the ideas of being big, adaptable, fearsome, radioactive. And it just didn’t seem right to use a term like ‘disruptive innovation’ or something to academic-y sounding, even though we are in an esteemed academic institution right now. So I came up with this term ‘thunder lizard’ about 20 years ago. And thunder lizards, for those of you who are not familiar with Godzilla, were hatched from radioactive atomic eggs. And this is actually the stage of the market that we, at Floodgate, like to invest in. And so we like to say that our job is to spot radioactive atomic eggs. When we invested in Twitter, they weren’t sure whether they were going to call it TWTR, or TWTTR, or Voicemail 2.0. And when we invested in Lyft before it launched, we had to get comfortable with the legal ambiguity of that service. And so at the time that we see this stuff, it’s hard to even know what it’s going to mutate into. But the goal is to find companies that have radioactivity at their roots. And then they swim across the ocean, and emerge with an attitude. And then they begin to devour their startup competitors right as they hit the beach. And then not long after that, they begin to disrupt even more, swiping holes into the sides of buildings, and then eventually, they attack the incumbents. The incumbents in the market are represented by those trains that he’s eating like sausage links. So now you know what thunder lizards are.” “My job is to spot radioactive eggs and to determine if they have that energy to morph into something, to mutate.”  “Of tens of thousands of companies started a year, 97 percent of the exit profits will likely come from less than ten….the point one percent. Our job is to find the point-one percent. But we have an extra twist. We want to avoid competing in a fiercely crowded landscape of established Series A funds. So we have to find these companies at the crazy, risky, and early time before Sand Hill Road is excited. When we are right, we will be rewarded because we will have been able to invest smaller amounts of money at lower valuations. That’s what makes our math work. So, as a general rule we like to see any startup idea that has the chance to be meaningful enough to be in the top point-one percent. But we try not to be too dogmatic about the areas we are focused on. We believe that knowing the rare exceptional startup when you see it is the more important skill.”

What I like about the term Thunder Lizard and I don’t like about Unicorn is that the “U” word does not refer to a business that has actually generated a financial exit for investors.  The term Unicorn encourages bad behavior. I actually use the term Grand Slam myself and definite that term like Maples does with Thunder Lizard to include an actual financial exit.

Maples says he is looking for “radioactive eggs” that can turn into “Thunder Lizards.” I like his taxonomy since not all startups are eggs that can eventually produce a lizard that is as powerful as Godzilla. There are more “radioactive eggs” today that are possible investments by top tier venture firms. Business formation in this Thunder Lizard category is up. But in the non Thunder Lizard category the numbers are down, This statistic makes the point: “the economy hatched 154,000 fewer new companies in 2014.”  A bicycle repair shop or food tuck are not a radioactive egg. To grow the economy and create new jobs we need lots more new business that are not radioactive eggs.

  1. “The first thing that I like to emphasize to people when they start a company is, start a company that’s worthy of your talents that you think represents the absolute utmost gift you have to offer to this world in your life. Because to be one of those, that’s what it takes. People shouldn’t just be doing a startup. Well, I should back up. If you decide to just be doing a startup, that’s fine. But that’s kind of like the decision to join a nonprofit. Or it’s kind of like a decision to– it’s kind of a labor of love, it may make the world better. But don’t do it because you think you’re going to make money approaching it that way. Because that’s not what the objective function of the industry is.”

Starting a business that has the potential to be a Thunder Lizard is far more of a calling rather than a rational act. Missionaries are far more likely to succeed than mercenaries when the act is not rational. It is impossible to fake the feeling that makes someone a missionary rather than a mercenary.  The founder may fool some of the people some of the time, but in the end the truth will come out. They will eventually hit one of the lows that are an inevitable part of what Ben Horowitz calls “the Struggle” and you will bail out. Hoping that the economics of the venture capital world will bend just for them is a triumph of hope over experience.

People say flying a commercial airplanes is composed of long periods of boredom interspersed with a few minutes of terror. A startup is the reverse: long periods of struggle and terror interspersed with a few minutes terror. Am I exaggerating a bit? Sure, comedy requires exaggeration. Did I often have a weird kind of fun and feel accomplishment when I was helping to build Teledesic? Absolutely. Would a team of mercenaries have been able to do what the team of Teledesic missionaries accomplished? No way. My startup experience give me lots to be humble about. I learned a lot. It was also financially rewarding for me since as I explained in my blog post on Teledesic, early investors and employees received a significant multiple on their investment or stock options. Later investor were not so lucky.

  1. “Bill Gates didn’t need to be in Silicon Valley to start Microsoft. Jeff Bezos didn’t need to be in Silicon Valley to start Amazon. Great companies happen because of great founders, not because of where they are or who the VCs are or any of that nonsense.” “I just don’t believe that VCs animate much. I believe that entrepreneurs animate things.”

There will never be another Silicon Valley. But other cities and regions can create a successful technology-driven economy in their own way. In order to achieve this goal, a city or region must and find its own comparative/competitive advantage. The best way to do that is to create a pool of great founders since venture capital will always follow great founders. As an example, when venture capital started in northern California the venture capitalists had their offices in San Francisco. When the founders moved south toward the Stanford campus the venture capitalists moved to Sand Hill Road. When the founders started moving back to San Francisco so did the venture capitalists. Another example of capital chasing great founders is Benchmark investing in Zillow in Seattle and Snap in Los Angeles. Money will always follow opportunity and the opportunity is created by great founders.

The best single way for a city to create a supply of great founders is to have at least one world class research university. Any city or region that wants to well in a modern economy that does not have a major research university is operating at a serious handicap. There are other things a city can do like having a culture that does not treat failure at trying something hard as anything but a great learning experience. Great K-12 schools, a diverse population and a healthy environment help too. Success feeds back on itself in that great founders inspire and attract more great founders.

One final note relates to the power laws that are pervasive in venture capital. With power laws most values are below average and a few outliers are far above. This means that average figures are close to meaningless. Power laws apply not just the distribution of success of venture-backed companies in a country or globally, but to the success of startups within a city or the success of venture firms operating in a city. For example if you take the “multiple on invested capital” of the top 10% of venture firms in Silicon Valley that MOIC will be far above the average MOIC since the distribution is not a bell curve. If you take the MOIC of the top 1% of venture firms in Silicon Valley, the MOIC will be even higher. In venture capital it is the outliers that matter most. This power law distribution exists in an industry but also within a city.

Notes:

Dare to do Legendary Things http://ecorner.stanford.edu/videos/3740/Dare-to-Do-Legendary-Things-Entire-Talk

Slide deck:  https://www.dropbox.com/s/z8io37mqoctale9/Capital%20Factory%20VC%20Primer%205-4-16%20PDF.pdf?dl=0

Slide deck: https://medium.com/@m2jr/beyond-lean-startups-pre-money-keynote-speech-from-6-22-16-11aa0257901b

Secrets https://austinstartups.com/finding-billion-dollar-secrets-95fb2b6489fb

Dare to Make your Startup Legendary https://medium.com/floodgate-fund/dare-to-make-your-startup-legendary-dc8eb68ba1fc

Vantor TV http://vator.tv/news/2016-01-15-meet-mike-maples-managing-partner-at-floodgate

Interview http://www.siliconhillsnews.com/2016/05/06/mike-maples-jr-talks-about-tncs-thunder-lizards-and-network-capitalism-at-longhorn-startup-demo-day/

Thunder Lizards https://techcrunch.com/2010/02/21/mike-maples-talks-venture-capital-and-thunder-lizards/

Forbes interview https://www.forbes.com/sites/petercohan/2012/12/11/how-mike-maples-jr-became-one-silicon-valleys-great-investors/#4c02eb41301c

Category Kings https://techcrunch.com/2016/10/10/floodgates-mike-maples-on-what-makes-category-kings/

Greylock post https://news.greylock.com/culture-is-how-you-act-when-no-one-is-looking-f29d5dd16ecb